Camp Meade, Maryland, winter views. Check the double exposure.
Ilargi: New home sales "unexpectedly" fell 0.6%, a number whose meaning is entirely nullified by its margin of error. But that is what was the headline all over again. The newsworthy bit follows only in the second or third paragraph of the reports. May new home sales were down 32.8% since May 2008. And that was not exactly a hot sales month to begin with.
In other words, the US housing market is slowly dying. It will never reach zero, there will always be some isolated sales, but it'll be close. Without the Home Affordable program, without the $8000 or-is-it-already $15.000 hands free government handout for buyers, and especially without the FHA, FHLB, Fannie Mae and Freddie Mac, there would be very little left in the way of US home sales at all. And soon there really won't be.
This CalculatedRisk graph explains a lot:
All the support the government can muster, combined with the ridiculous "green shoots you can believe in" media and advertising campaigns, has succeeded in halting the fall for a bit, and only just. But look at the differences from just a few years ago:
Really, every single poor soul who buys a home these days using a mortgage doesn't just sign a loan, s/he also signs a debt servitude conviction. When everyone wakes up the fact that the government can't keep up the housing illusion forever, that prices will go where demand and supply takes them regardless of the amount of subsidies offered, we'lll see those prices go to depths we never knew existed. Think Detroit City's $6000 average sales price. That will also be the end of the banking system.
Plus, the entire construction industry, and all of its suppliers, are dead in the water for years to come. Housing repairs may remain at some level or another, but far fewer people than you may anticipate will have the money to pay for repairs. Springsteen's "My city in ruins” will take on a new meaning.
My City In Ruins
There is a blood red circle
On the cold dark ground
And the rain is falling down
The church door's thrown open
I can hear the organ's song
But the congregation's gone
My city of ruins
My city of ruins
Now the sweet bells of mercy
Drift through the evening trees
Young men on the corner
Like scattered leaves,
The boarded up windows,
The empty streets
While my brother's down on his knees
My city of ruins
My city of ruins
Come on, rise up! Come on, rise up!
Come on, rise up! Come on, rise up!
Come on, rise up! Come on, rise up!
Now's there's tears on the pillow
Darlin' where we slept
And you took my heart when you left
Without your sweet kiss
My soul is lost, my friend
Tell me how do I begin again?
My city's in ruins
My city's in ruins
Now with these hands,
With these hands,
With these hands,
I pray Lord
With these hands,
With these hands,
I pray for the strength, Lord
With these hands,
With these hands,
I pray for the faith, Lord
We pray for your love, Lord
We pray for the lost, Lord
We pray for this world, Lord
We pray for the strength, Lord
We pray for the strength, Lord
U.S. May home sales slip to 342,000, decline 32.8% from May 2008
Sales of new U.S. single-family homes slipped slightly in May, according to Commerce Department data on Wednesday that underscored that conditions in the hard-hit housing market remain fragile. The annual sales pace of 342,000 was a 0.6 percent decline from April. Economists polled by Reuters had forecast sales would notch a 360,000 rate. It also remained far below the 509,000 annual pace of May 2008.
But the median sales price rose to $221,600 from $212,600 in April and was the highest since December, when it was $229,600. The median marks the half-way point, with half of all houses sold above that level and half below. Economists believe the U.S. housing market will not begin to recover until home prices fall far enough to stimulate demand that will whittle down the overhang of unsold homes.
Inventories of new homes for sale fell 2.3 percent 292.000 in May, the lowest level since March 2001. At the current pace of sales, this means it would take 10.2 months to clear stocks of unsold new homes, down from 10.4 months at last month's sales pace.
Durable goods orders up in May; new home sales dip
Orders to U.S. factories for manufactured goods from computers to aircraft surged in May for a second straight month. And a gauge of business investment rose last month by the most in nearly five years. Together, the data Wednesday signal that the recession could be at or near a bottom. Yet new-home sales fell unexpectedly last month. It was a reminder that any recovery in the housing market will be long and slow.
Even so, investors focused on the positive news on durable-good orders and business investment, before Federal Reserve policymakers announce their decision on interest rates Wednesday afternoon. The Dow Jones industrial average added about 80 points in midmorning trading. Broader stock averages also surged more than 1 percent. The Commerce Department said demand for durable goods rose 1.8 percent last month, far better than the 0.6 percent decline that economists expected. It matched the rise in April, with both months posting the best performance since December 2007, when the recession began.
Orders for non-defense capital goods, a proxy for business investment plans, jumped 4.8 percent, the biggest increase since September 2004. That could signal that businesses have stopped trimming their investment spending. The back-to-back monthly gains in orders for durable goods - items expected to last at least three years - were further evidence that a dismal stretch for U.S. manufacturers may be nearing an end. But analysts say any sustained rebound is months away.
"This is a pretty good report and welcome news in the hard-pressed (capital expenditure) sector," M. Cary Leahey, an economist at New York-based consulting firm Decision Economics, wrote in a research note. Still, new new-home sales dropped 0.6 percent in May to a seasonally adjusted annual rate of 342,000, from a downwardly revised April rate of 344,000. Economists had expected a sales pace of 360,000 last month, according to Thomson Reuters. Sales were down nearly 33 percent from May last year.
The median sales price, $221,600, was down 3.4 percent from a year earlier but up 4.2 percent from April. American companies have been forced to trim millions of workers as they struggle with the longest U.S. recession since World War II. U.S. businesses also have suffered from a sharp drop in exports as many overseas markets struggle with their own downturns. Excluding transportation, orders for durable goods posted a 1.1 percent rise in May, also better than the 0.4 percent drop that had been expected. Demand for transportation products rose 3.6 percent. That reflected a 68.1 percent jump in orders for commercial aircraft, a volatile category that had fallen 1.4 percent the previous month.
The big increase in aircraft offset further weakness in the troubled auto sector. Demand for motor vehicles and parts fell 8.1 percent in May, signaling disruptions from the bankruptcy filings at Chrysler LLC and General Motors Corp. Orders for machinery rose 7.7 percent last month. Demand for computers and related products surged 9.4 percent. The overall economy, as measured by the gross domestic product, shrank at annual rates of 6.3 percent in the final three months of last year and 5.7 percent in the January-March quarter - the worst six-month stretch for the GDP in more than 50 years. The government is scheduled to revise the first-quarter GDP figure Thursday, but analysts expect the revision will leave the overall figure unchanged.
U.S. economists at Deutsche Bank cautioned that "if the rest of the economy turns out to be weak, new orders for durables could ultimately be canceled." Many economists say that GDP in the current quarter will show a much smaller decline, around 2 percent, with growth returning in the second half of this year. "The U.S. economy is weak but no longer in free fall," Leahey said. Most economists do not think the unemployment rate will turn around quickly. The jobless rate jumped to a 25-year high of 9.4 percent in May, and many economists say it could top 10 percent before the recovery gains enough strength to push unemployment lower.
California to Pay Creditors With I.O.U.’s
Signaling that California is slipping deeper into financial crisis, the state’s controller said Wednesday that his office would soon be forced to issue i.o.u.’s to scores of the state’s creditors, the first time since 1992, when 100,000 state employees were paid with them. Before that budget crisis — which pales in comparison to the current shortfall, even with inflation adjustments — the last time California issued the documents was during the Depression, something the controller, John Chiang, alluded to in his news release announcing the impending action.
“Next Wednesday we start a fiscal year with a massively unbalanced spending plan and a cash shortfall not seen since the Great Depression,” Mr. Chiang said in a written statement. “The State’s $2.8 billion cash shortage in July grows to $6.5 billion in September, and after that we see a double-digit freefall. Unfortunately, the State’s inability to balance its checkbook will now mean short-changing taxpayers, local governments and small businesses.”
The issuing of the i.o.u.’s would reflect the state’s lack of cash flow and its legislature’s inability to agree on a way to close a roughly $24 billion budget gap, as tax revenues have continued to fall in the state. On Wednesday, as Mr. Chiang made his announcement, legislators continued to debate ways to close the gap in preparing for a vote on a budget presented by Democrats that was all but certain to fail on the floor.
Democrats want to close the gap with a mix of vast cuts to social programs and an increase to cigarette, oil drilling and car taxes; Gov. Arnold Schwarzenegger, a Republican, has vowed to veto any and all tax hikes, and his party’s lawmakers agree with him. In February, lawmakers passed a budget for both 2009 and 2010, but the legislation, which covered 17 months’ worth of spending, was dependent on the passage of several ballot propositions that that were rejected by California voters in May. As a result, the state’s budget gap expanded.
In response, Governor Schwarzenegger has proposed $16 billion in cuts. Those cuts would largely be carried out through the state’s programs for the poor: the Healthy Family Program, the health insurance program that covers more than 900,000 children; the main welfare program, known as CalWorks, which provides temporary financial assistance to poor families; and Cal Grants, a college financial aid program. He also wants to borrow millions from local governments and release some prisoners early to save money. Republican lawmakers are more or less on board with the governor other than the plan to borrow from localities and release prisoners or lay off any corrections officers.
“The consequences of inaction just shot up dramatically,” said H. D. Palmer, the spokesman for the state’s Department of Finance, in an e-mail message. “This underscores just how serious this situation is, and why it’s absolutely critical for the Legislature to get a budget package to the Governor in a form that he can sign — and do it in a matter of days.” If all sides cannot come to an agreement by July 2, millions of dollars in the unusual i.o.u.’s will be issued, including $159 million to the Student Aid Department and hundreds of millions to social services agencies across the state.
The controller delayed payments for 30 days in February to manage a cash crisis at that time, but i.o.u.’s represent a far larger shortfall that would likely be impossible to cover with simple delays. An attempt to borrow money to cover the shortfalls, which is usually done as the legislature bickers its ways to a budget this time of year, was impossible this June because the banks that usually make such loans are unable to do so, and the Obama administration refused a request to back loans as well.
According to the controller’s news release, the i.o.u.’s will carry an interest rate set by the state’s Pooled Money Investment Board, which will hold an emergency meeting at his request on July 2 to set the rate. Any rate adoption would become effective immediately; the i.o.u.’s will have a maturity date of Oct. 1, 2009. In 1992, Gov. Pete Wilson, a Republican, issued the i.o.u.’s to state workers; the workers immediately brought a lawsuit, contending that the i.o.u.’s violated the federal Fair Labor Standards Act. A federal judge approved a $558 million settlement, and some workers received additional vacation time.
Credit-default swaps are pitting firms against their own creditors
Six Flags, an American theme-park operator, filed for Chapter 11 bankruptcy protection on June 13th, bringing its long ride to reduce debt obligations to an abrupt halt. The surprise was that bondholders, not the tepid credit markets, stymied the restructuring effort. Bankruptcy codes assume that creditors always attempt to keep solvent firms out of bankruptcy. Six Flags and others are finding that financial innovation has undermined that premise.
Pragmatic lenders who hedged their economic exposure through credit-default swaps (CDSs), a type of insurance against default, can often make higher returns from CDS payouts than from out-of-court restructuring plans. In the case of Six Flags, fingers are pointing at a Fidelity mutual fund for turning down an offer that would have granted unsecured creditors an 85% equity stake.
Mike Simonton, an analyst at Fitch, a ratings agency, calculates that uninsured bondholders will receive less than 10% of the equity now that Six Flags has filed for protection.
Some investors take an even more predatory approach. By purchasing a material amount of a firm’s debt in conjunction with a disproportionately large number of CDS contracts, rapacious lenders (mostly hedge funds) can render bankruptcy more attractive than solvency.
Henry Hu of the University of Texas calls this phenomenon the “empty creditor” problem. About two years ago Mr Hu began noticing odd behaviour in bankruptcy proceedings—one bemused courtroom witnessed a junior creditor argue that the valuation placed on a firm was too high. With default rates climbing, he sees such perverse incentives as a looming threat to financial stability.
Already the bankruptcies of AbitibiBowater, a paper manufacturer, and General Growth Properties, a property investor, in mid-April have been blamed on bondholders with unusual economic exposures. Some also suspect that CDS contracts played a role in General Motors’ filing earlier this month. Solutions to the problem are, so far, purely theoretical. One option would be regulation requiring disclosure by investors of all credit-linked positions.
There is now almost no disclosure of who owns derivatives on a company’s debt, leaving firms to guess how amenable creditors will be when approached with a restructuring plan. Longer-term solutions rest on an overhaul of the bankruptcy code and debt agreements to award votes and control based on net economic exposure, rather than the nominal amount of debt owned. Supporters of the market point to the value of CDSs in reducing the cost of capital and to plans for a central clearing house that will reduce redundancy and increase transparency. But the reform roller-coaster has not yet come to a halt.
US credit card chargeoffs break new record - Moody's
The U.S. monthly credit card chargeoff rate surpassed 10 percent and hit a sixth straight record high in May, Moody's Investors Services said on Wednesday, as unemployment grew to a 26-year high. The chargeoff rate index -- which measures credit card loans the banks do not expect to be repaid -- rose to 10.62 percent in May from 9.97 percent in April. "We expect the chargeoff rate index to continue to rise in the coming months but at a slower pace, as it peaks at around 12 percent in the second quarter of 2010," Moody's senior vice president William Black said in a statement.
The Moody's index also showed delinquencies -- monthly payments more than 30 days late -- fell to 5.97 percent in May from 6.34 percent in April. However, the agency said it was due to a seasonal trend, as consumers used tax refunds to pay back debts, and estimated delinquencies will resume their upward trend. Credit card losses usually follow the trend of unemployment, which rose in May to 9.4 percent and is expected to peak over 10 percent by the end of 2009.
With credit card losses across the industry surpassing the 10 percent this year, loan losses in the industry could top $70 billion, according to analysts' estimates. According to data released by credit card companies earlier this month, based on on the performance of loans that were securitized, defaults rose across the board in May, with a steep deterioration of Bank of America Corp's lending portfolio.
American Express Co. -- the largest U.S. credit card company by sales volume -- and Citigroup Inc. -- the largest issuer of MasterCard branded credit cards -- also showed big credit card losses. However, JPMorgan Chase and Co. -- the largest issuer of Visa branded credit cards --, Discover Financial Services, and Capital One Financial Corp., showed better than expected default rates.
Ilargi: Zero Hedge delivers a scanned version (Rolling Stone has no digital version available yet) of Matt Taibbi's damnation of Glodman Sachs and, by extension, the entire US financial system. I suggest you save the file as a pdf. See under MORE in the document menu bar.
"Goldman Sachs Engineered Every Major Market Manipulation Since The Great Depression"
With a subtitle like "From tech stocks to high gas prices, Goldman Sachs has engineered every major market manipulation since the Great Depression - and they're about to do it again" run, don't walk, to your nearest kiosk and buy Matt Taibbi's latest piece in Rolling Stone magazine. One of the best comprehensive profiles of Government Sachs done to date. Speaking of GS, they sure must be busy today, now that Bernanke is about to be impeached and take the fall for all their machinations.
Warren Buffett compliments Bernanke and Geithner
Billionaire Warren Buffett says the United States has a good team leading the Treasury Department and Federal Reserve as it fights what he's called an economic war. Berkshire Hathaway's chairman and chief executive says he can't see how the nation could do better than Ben Bernanke as Federal Reserve chairman.
Buffett said during an interview on CNBC Wednesday that Bernanke took decisive action at a time when the nation's economy needed that. Buffett also complimented Treasury Secretary Timothy Geithner. Buffett says he's sure the actions the government has taken in the past year to help the economy will result in high inflation down the road. But he says the government's actions were appropriate.
Fed engaged in "cover-up" of BofA-Merrill deal-lawmaker
The Federal Reserve sought to hide its extensive involvement and concerns about Bank of America Corp's acquisition of Merrill Lynch amid the latter's worsening financial condition, a top Republican congressman said on Wednesday. "The committee has already learned that Ben Bernanke and the Federal Reserve made inappropriate threats to fire Bank of America management unless they went ahead with the 'shotgun wedding' that was the Merrill Lynch acquisition," Rep. Darrell Issa of the House Oversight and Government Reform Committee said in a statement released to Reuters.
"The Federal Reserve also engaged in a cover-up and deliberately hid concerns and pertinent details regarding the merger from other federal regulatory agencies," the statement said. The committee has obtained a number of emails and documents from the U.S. central bank about its behind-the-scenes role in the merger, according to sources familiar with documents.
Fed Leaves Rates Near Zero; Econ Contraction Slowing
U.S. Federal Reserve policy makers on Wednesday held rates near zero while highlighting fresh signs of economic stability. "Information received since the Federal Open Market Committee met in April suggests that the pace of economic contraction is slowing," said the statement officials released after their interest rate policy meeting. "Conditions in financial markets have generally improved in recent months." The FOMC voted 10-0 to maintain the target federal-funds rate for interbank lending at a record-low range of zero to 0.25%. At the same time, they reiterated that they're likely to keep rates at low levels for an extended period.
In the statement, policy makers said household spending has shown further signs of stabilization even amid job losses and tight credit. Additionally, businesses are cutting back, but they seem to be better at matching up inventory with sales, the Fed said. It added that it believes its actions to date will help put the economy on a path toward recovery. "They have a little bit more conviction that the recession is tapering off and less concern about deflation," said Zach Pandl, economist at Nomura.
The discount rate for commercial and investment banks was also left unchanged, at 0.5%. Both rate decisions were in line with Wall Street economists' expectations. What's more interesting is what the Fed didn't do. Despite a recent rise in long-term interest rates, policy makers didn't tweak their plans to purchase mortgage-backed securities and Treasurys. They kept intact plans to purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. As previously announced, they plan to buy up to $300 billion of Treasurys by autumn.
Still, as they've done before, Fed officials said they would continue to evaluate the timing and overall amounts of their securities purchases in light of evolving economic conditions. Fed officials weren't expected to unveil any new dramatic announcements. Rather, many economists believe the Fed has entered a new, more steady phase in which it will be monitoring the various programs it has already launched to stem the financial crisis. Current economic conditions give the Fed plenty of room to stay pat and continue to monitor the impact of existing programs.
Many economists expect that the unemployment rate, which rose to a 26-year high of 9.4% last month, will only continue to creep up into next year. Earlier this week, White House spokesman Robert Gibbs said it's likely the U.S. jobless rate will reach 10% in the next few months. Meanwhile, near-term inflation remains in check. Consumer price data from May showed the largest decline in 59 years. "The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time," the statement said.
However, officials deleted previous references to the risk that inflation could persist below desired rates, an indication that they don't see deflation as a risk. Still, the FOMC faces a set of new significant policy challenges as the economy slowly moves out of crisis mode. Instead of launching new, emergency programs and loosening monetary policy, officials' focus will turn to exit strategies. Although many economists don't see the Fed unwinding programs soon, policy makers are having to discuss strategies for closing out programs in a way that doesn't stoke inflation.
Earlier this month, Federal Reserve Chairman Ben Bernanke said he expects to see economic growth this year, but it won't be robust. Backing up that forecast are recent data on jobless claims, signs of stability in housing and a report Wednesday that showed a pickup in durable goods orders, among other things. Bernanke has also said the Fed will remove policy accommodation at the right time and at the right speed even as he acknowledged it will be a tricky endeavor.
Tightening credit puts a squeeze on business owners
For small-business owners who rely on business credit cards, the recessionary landscape looks extra bleak these days. OfficeMax Inc. is no longer accepting its own credit cards after the financial company that ran its program and made the loans terminated the arrangement last month. About 100,000 small businesses were affected by the move, the national office supply retailer said. It's the latest blow to a small-business community still stinging from last month's cancellation by Advanta Corp. of all its small-business credit cards.
The step, taken with little notice after the company wrote off a record cache of loans as uncollectable, took more than 1 million account holders by surprise. Interest rates are shooting up; Advanta hiked its rates into the 30%-plus range for some cardholders before shutting them off completely. Other card issuers have raised rates and cut credit limits, often with little warning. At the same time, issuers are requiring higher credit scores for new cards as part of tightened underwriting. Card companies are no longer chasing small businesses with competing deals.
"There has been a huge contraction in how aggressively these offers are marketed," said Curtis Arnold, chief executive of CardRatings.com. Instead of card solicitations, the mail is more likely to bring bad news. "Every time I open an envelope, there is a Chase or Advanta or somebody either saying your credit line is cut or interest rate is going up," said Kirby Newbury, co-owner of DiscountCoffee.com, a 20-employee firm near St. Louis that ships coffee, juice and tea to businesses and consumers nationwide, including a slew of Los Angeles-area entertainment and media firms.
Credit card and home equity loans were two pillars of small-business financing in recent years as home values soared and banks and finance companies competed to win over small firms with 0% interest teaser rates and juicy credit card rewards for office supplies, shipping and gasoline.
Both sources have contracted, with little relief in sight, leaving business operators without tools they used to manage monthly cash flow, streamline accounting and build or maintain business credit. Office Max is working on offering a new credit product through a different bank in the "near future," a spokeswoman said. But industry watchers expect the credit card business, struggling with record default rates, to remain stingier with the unsecured loans that credit cards provide.
Advanta's credit card shutdown was blamed in part on a loan charge-off rate that soared to 16% in the first three months of the year, nearly double some of its competitors' rates. That compared with Advanta's level of about 6% in the year-earlier period. The industrywide rate is growing at a worrisome speed as struggling cardholders fall behind on payments and banks and finance companies try to get loans off their books to limit their exposure to risk. Some estimates show the average charge-off rate hitting 22.5% by the end of 2010.
The rates are the result of several factors, including the difficulty small-business owners are having paying their bills as their sales drop and the loose underwriting standards many card issuers had followed. Small-business owners are considered by some industry observers to be higher credit risks than consumers because they may be more willing to walk away from their business credit cards. No one is predicting the credit card industry will cut off small-business owners completely.
Discover, which had been working to get more businesses to accept credit cards for business-to-business purchases traditionally billed directly, still offers its small-business cards, although introductory rates are now 10.99%. American Express still offers business cards through its OPEN American Express program. A major question mark is the plans of the company that issued OfficeMax credit cards: HSBC North America Inc.'s retail services group. At one point, the group offered private-label credit cards for up to 37 retailers, according to its website. Those included OfficeMax, Best Buy, Neiman Marcus and Bon-Ton.
In March, the global company said it would shut down its subprime mortgage services, consumer finance and vehicle finance arms -- the former Beneficial Finance and Household Finance companies that it acquired in 2003. As retailers struggle, some industry observers question whether HSBC will retain all of its U.S. credit card business. The company seemed to raise the possibility at its recent annual meeting in London, although a company spokeswoman said the subsequent reporting took the comments "somewhat" out of context.
Kate Fitzgerald, who follows credit card issuers as associate editor at Cards & Programs trade magazine, picked up on the report, which said that any decision was unlikely for at least 18 months. "HSBC is one issuer that recently made noises they might exit the credit card industry," she said. Such a move could further disrupt small-business owners' access to credit. Newbury said he lost a $41,500 line of credit -- a big chunk of the $250,000 he has in credit lines on credit cards -- when his Advanta card was canceled.
The business owner said he typically pays off his balances each month but relies on credit cards for purchases such as the warehouse lighting he ordered from a California company recently. Author and freelance writer Donna Stone relied on her Advanta card to support book signings, book festivals and book development expenses. "As a low-budget author, it has allowed me to easily separate my business expenses from my personal budget," Stone wrote in a recent e-mail. "I am concerned about where I will find a comparable tool to support my business, my livelihood and my life."
As Bankruptcies Surge, Fewer Emerge
Business bankruptcy filings are up more than 40% from a year ago, and banks are pushing more companies to liquidate. As the effects of the recession continue, the high number of business bankruptcies—7,514 in May, up 40% from the prior year—shows few signs of abating. That's because the factors pushing companies into bankruptcy, including depressed sales and tighter credit, may linger even when the economy starts growing again, especially if the recovery is less than robust.
More than 100,000 companies—about one in every 270 American businesses—have landed in bankruptcy court since the downturn began 18 months ago, according to data compiled by Oklahoma City-based Jupiter eSources, which tracks bankruptcy filings through its AACER database. The rate of commercial bankruptcies has more than doubled in two years, and economists expect the level to remain high for a year or longer once the recession ends. In addition, creditors are less willing to work with business owners to find ways for an insolvent firm to recover.
That's because in a sluggish recovery, banks with already fragile balance sheets are unlikely to be sympathetic to debtors' turnaround plans. Often creditors recover more of their debts faster by closing bankrupt businesses and selling off the assets. "Today lenders—meaning banks—have much less patience for a traditional Chapter 11 reorganization, no matter what size the case," says attorney Kenneth Rosen, head of the bankruptcy group at Lowenstein Sandler in Roseland, N.J. Statistics measuring business bankruptcies are notoriously difficult.
U.S. Courts records show business bankruptcies make up between 3% to 5% of all filings. But research by bankruptcy scholars Robert Lawless and Elizabeth Warren (the latter is now head of the TARP oversight panel) suggests that filings related to a business failure make up closer to 15%. Jupiter eSources' database, AACER, which stands for Automated Access to Electronic Court Records, counts an individual filing with a "doing business as" name or a taxpayer ID number as a commercial bankruptcy. Those filings include business owners whom U.S. Courts records might count as consumers.
Regardless of the discrepancies, both AACER and U.S. Courts data show increasing business filings. Euler Hermes, which provides insurance against defaults by trading partners, expects business bankruptcies to rise by 45% this year over 2008, and decline only slightly in 2010. The firm estimates that on average, "it takes GDP growth of 2% to 3% to stem the rise in insolvencies." A slow, "L-shaped" recovery could extend the high rate of business filings, says Harlan Platt, a finance professor at Northeastern University who has studied bankruptcies.
"I think the surge in commercial bankruptcies is probably not yet here," he says. The business cycle is only one factor that affects bankruptcy rates. Lawless, a professor at the University of Illinois College of Law, says the availability of credit is more important than GDP growth. "I don't expect that to really ease," he says. In the short term, Lawless says bankruptcies are usually triggered by some interruption in income. While that might mean a layoff for a wage earner, declining sales for a business owner could make them insolvent.
Bankruptcies also don't measure the broader rate of business failures. "The bulk of closures, believe it or not, do not leave debt behind in a way that leads business owners to seek bankruptcy protection," says Brian Headd, an economist with the Small Business Administration's Office of Advocacy. For example, about 1.15 million businesses closed their doors in the first three quarters of 2008, according to the latest data from the Bureau of Labor Statistics. (That figure includes companies that closed without being in distress—if the owner retires, for example.) Only a small fraction filed for bankruptcy protection. That may be in part because bankruptcy proceedings are expensive and, in most cases, unlikely to position the company for a turnaround, says Lowenstein Sandler's Rosen.
The retainer for a Chapter 11 case for a company with less than $10 million in annual sales ranges from $25,000 to $50,000. In addition, the bankrupt business typically pays the legal and accounting fees of creditors. Increasingly, Rosen says, both debtors and creditors benefit from out-of-court settlements that avoid the expense and time of a bankruptcy case. Indeed, the vast majority of business bankruptcies are Chapter 7 liquidations, in which the company ceases operations and its assets are sold to pay off lenders. So far in 2009, just 18% of business filings have been Chapter 11, according to AACER. Creditors are also unlikely to agree to dubious turnaround plans. "They say if I force you to liquidate, I'm going to recover maybe 80% of my money right away, instead of waiting two years and maybe recovering less," says Northeastern's Platt.
World Wealth Down 19.5% In '08
The economic crisis took a harsh toll on the world's wealth, wiping out two years of growth and reducing both the number of high-net-worth individuals and their total wealth to below 2005 levels. In 2008, the world's population of high-net-worth individuals - those with at least $1 million in investable assets excluding primary residences - fell by 14.9% to 8.6 million and their wealth dropped 19.5% to $32.8 trillion, according to the 13th annual World Wealth Report, compiled by Bank of America Corp.'s Merrill Lynch Global Wealth Management and Capgemini Group. In 2007, the same population grew by 6% to 10.1 million and marked the beginning of a deceleration in wealth from the 11.4% growth witnessed in 2006.
Ultra-high-net-worth individuals - those having investable assets of at least $30 million -suffered an even steeper decline of 24.6%, largely a result of this group's inclination toward more aggressive products that delivered hefty losses in 2008, the report said. "This is not surprising given the nearly 50% plunge in global equity market cap and global GDP, said Dan Sontag, president of Merrill Lynch Global Wealth Management. While the world's wealth is still concentrated in three areas - U.S., Japan and Germany - the ranks are continuing to shift.
The U.S. saw a sharp 18.5% decline in the number of millionaires, but remains the largest home to high-net-worth individuals, with its 2.5 million HNWIs accounting for 28.7% of the global HNWI population. China's HNWI population surpassed that of the U.K. to hit the rankings at number four in list of countries having the most wealthy individuals and Brazil jumped two spots from 2007 to make the top ten. Some of the nations that were at the forefront of global wealth growth in 2006 and 2007 saw some of the larger drops, indicating that while volatility may be good on the way up it can be devastating on the way down.
For instance, India's HNWI population shrank 31.6%, the second largest decline in the world, after posting the fastest rate of growth (up 22.7%) in 2007. India, still an emerging country, suffered from the decline in global demand for its goods and services and a large drop in market capitalization (64.1% in 2008). Likewise, Russia's HNWI population declined 28.5% after growing at 14.4% in 2007, due mainly to a decline in global demand for oil and gas. Just as no country was left untouched, there were no safe havens for investments in 2008, Sontag said.
The economic downturn led high-net-worth individuals to seek refuge in cash, fixed income and domestic investments. The wealthy reduced their exposure to equities across the globe and by year-end 2008, equities accounted for 25% of total global HNWI financial assets, down from 33% a year earlier. Of global HNWI assets, 21% were in cash-based holdings in 2008, up 7 percentage points from pre-crisis levels in 2006. In the short term, HNWI are expected to remain moderately conservative in their investment allocations, with capital preservation taking priority over the pursuit of high returns, the report said.
As economic conditions improve and the wealthy regain their risk appetite, they are expected to move some of their increased allocations of cash and short-term deposits into longer-term, higher-yielding instruments. "We think it's already easing now and we're encouraging clients to return to higher risk assets and away from capital preservation instruments as conditions improve," Sontag said. Going forward,the report forecasts HNWI financial wealth to resume growth as the global economy recovers.
Financial wealth will grow to $48.5 trillion by 2013, led by North America and Asia Pacific, the report said. Latin America is poised to grow again when the U.S. and Asian economies start to pick up due to a demand for its commodities and manufacturing capabilities. Asia-Pacific is expected to surpass North America by 2013, driven by increased U.S. consumer expenditure and newfound autonomy for the Chinese economy, Sontag said. "55 millionaires a day are being created in China and that growth is going to convert the entire Asian region," Sontag said.
Mortgage Bombs, Quiet for Now, Await Next Boom
Here’s a way to help head off the next financial crisis: Make sure borrowers have some of their own money on the line. That’s a no-brainer. Not, though, for Congress and regulators. They squandered a chance after the early 1990s housing slump to require borrowers to put up a decent amount of their own cash when getting a mortgage. That failure, which paved the way for no-money-down loans and worse, shows how reform efforts can wither in the face of bank lobbying.
And, as Congress considers President Barack Obama’s grand regulatory overhaul, focused largely on too-big- to-fail financial institutions, it’s also a reminder that simple solutions are sometimes the best. The reason for requiring borrowers to put their own money down: they will be less likely to roll the dice on risky loans or jump into speculative plays. That should defuse the temptation for bankers to create mortgage bombs during booms. Congress acknowledged this after the last housing bust, according to an article in this month’s “Economic Letter” from the Federal Reserve Bank of Dallas.
At that time, a reform push got under way “with a sense of urgency, when lawmakers, stung by a banking crisis, prepared to set limits on the aggressiveness of real estate lending,” wroteJeffery Gunther, a staffer in the Dallas Fed’s financial industry studies department. What came next is an oft-heard tale. Banks thwarted proposed changes that threatened their profits. Forcing borrowers to pony up more cash shrinks the number of people who can get loans. That means banks can’t lend as much, crimping their growth, profits and, ultimately, share prices.
At least that was the thinking before many of these loans went into the toilet, saddling banks with losses that erased much, and in some cases all, of those profits. This time around, banks have another reason to fight any change. If a simple solution like a hard-and-fast cap on the size of a loan relative to a property’s value would help prevent future crises, the causes of the current one can’t be that complicated.
This runs counter to the credit-crunch story spun by banks that our problems are due to a complex set of economic, social and political circumstances well outside their control. The Dallas Fed’s Gunther pushes back on that notion. “It’s important to acknowledge the immediate source of today’s financial turmoil isn’t new or terribly complicated,” he wrote. “The crisis is merely the latest manifestation of an old problem -- credit booms fueled by loose lending tied to rising asset prices, followed by asset-price busts that bring severe tightening of lending practices.”
The fact that many homeowners had little of their own money, or equity, in their properties, only made today’s crisis worse. Decades ago, borrowers typically had to put down money equal to 20 percent of a property’s value to qualify for a mortgage. Over time, that fell to 10 percent and in some cases 5 percent. The recent housing boom lowered the bar even more. There were no-money-down mortgages, or loans in which the equity was actually a second, “piggyback” mortgage.
As if that wasn’t bad enough, some borrowers had negative equity thanks to loans that added to the total amount owed when the borrower opted to skip an interest or principal payment. When housing markets cratered, it made more sense for many of these borrowers to walk away from a house rather than try to hold on. That fed the foreclosure wave. Gunther noted that by some estimates, mortgages that exceeded 90 percent of a property’s value accounted for 35 percent to 40 percent of subprime originations in 2005 and 2006. And these tended to be the loans that performed the worst.
How was this possible, given that regulators were aware of the loan-to-value problem in the early 1990s? Early versions of legislation called the Federal Deposit Insurance Corp. Improvement Act of 1991 included caps on the ratio of a loan’s value to an underlying property. The caps didn’t make it into the final version of the law. Instead Congress told regulators to establish standards for real-estate lending. That would have been fine if resulting regulation put caps in place.
Enter the bankers, who “claimed the proposed regulation would have been costly, inflexible, misdirected and antigrowth,” Gunther wrote. “Regulators responded much like Congress did before them, reversing course and deciding against imposing the regulation on loan-to-value limits.” Instead, they issued guidelines -- a bureaucratic wet noodle -- that remain in place today. Not having the weight of law or regulation, these guidelines were often ignored or only loosely enforced. That helped lead us into our current predicament.
The crisis has now forced banks to return to more conservative ways; many now require borrowers to put down 20 percent or more of a property’s purchase price. That’s welcome -- as long as it lasts. Unless Congress acts on this obvious problem this time around, banks will go back to their loose ways come the next boom.
Moody’s Says World Has 'No Credible Alternative' to U.S. Dollar
Moody’s Investors Service said the dollar’s unchallenged status as the world’s reserve currency is supporting U.S.’s Aaa credit rating even as the nation’s budget deficit is set to quadruple this year. “In the absence of a credible alternative it’s hard to see abrupt changes and that’s not even in the interest of the creditors,” Pierre Cailleteau, managing director of sovereign risk at Moody’s, said in an interview in Tokyo yesterday. The credit rating “remains solid,” he said earlier at a briefing.
The fiscal health of the world’s largest economy has come under scrutiny by its creditors as bailouts and stimulus plans swell a budget deficit forecast to soar to a record $1.85 trillion this year. China and Russia, the largest and third- largest foreign holders of the debt, have said they may diversify some of their reserves. Even if the U.S.’s ratio of debt to gross domestic product were to exceed 100 percent, more than double the current level, the country’s rating would still be secure as long as borrowing costs stay low, Cailleteau said. Moody’s estimates the ratio will rise to 59.9 percent this year from 40.8 percent.
“In the U.S., interest rates are low because the debt is issued in its own currency and the currency happens to be the international reserve currency,” he said. Yields on benchmark 10-year Treasuries have risen to 3.63 percent since touching a record low 2.04 percent in December. They rose to their highest level since October this month after Alexei Ulyukayev, first deputy chairman of Russia’s central bank, said on June 10 his country may switch some of its Treasury holdings to International Monetary Fund bonds.
China, which in March called for the U.S. to guarantee the safety of China’s assets, is still buying Treasuries. Premier Wen Jiabao’s government has increased its holdings of the securities by almost a quarter to $763.5 billion since the onset of the global credit crisis in September, according to U.S. Treasury data. “The question you have to ask is: What does it mean to be a safe haven in the end?” Cailleteau said. “The test is that when you have a big problem, either in the economy or if you have the threat of a war, where do you think people are going to put their money?”
Policy makers have indicated there is no replacement for the dollar. Russian Finance Minister Alexei Kudrin said on June 13 that “it’s too early to speak of an alternative.” Japanese Finance Minister Kaoru Yosano, whose government is the largest holder of Treasuries after China, this month said the dollar should remain the world’s reserve currency. U.S. President Barack Obama has said that it is important his nation maintains fiscal discipline to ensure investors keep buying Treasuries. He plans to cut the deficit by half before the end of his first term.
“Even if he’s wrong, even if he’s too optimistic, that doesn’t necessarily meant we’ll have to act,” Cailleteau said. “The U.S. started the crisis in pretty good shape in terms of government finances.” The global recession has put pressure on economies and government budgets around the world, forcing Moody’s to reconsider the credit quality required by the ratings, Cailleteau said. “It’s a scale that is anchored on the Aaa rating and the Aaa anchor is drifting. Most Aaa governments are affected,” he said, adding that the U.S is “losing altitude” in the top range.
ECB pumps record €442bn into system
The European Central Bank has pumped a record €442.2bn into the eurozone banking system in a first-ever offer of unlimited one-year funds as it battles continental Europe’s severe recession. The results of the operation, part of ECB efforts to revive the eurozone economy by rejuvenating the financial system, highlighted expectations that liquidity will not be available again on such favourable conditions. The previous largest amount injected in a single ECB operation was €348.6bn in December 2007.
Demand for the one year funds – offered at the ECB’s main policy rate of just 1 per cent – appears to have been boosted significantly by financial markets’ growing conviction that ECB interest rates will not fall any further. The operation is expected to push down significantly market borrowing costs, including 12 month interest rates, which are already lower than in the US. Julian Callow, European economist at Barclays Capital, added: “This gives the banking sector greater confidence still in order to be able to make loans and acquire assets.”
Since the collapse of Lehman Brothers last September, the ECB has slashed its main policy rate by 325 basis points to the lowest ever rate. But ECB policymakers have signalled that further reductions are unlikely – unless the eurozone economy takes a substantial further turn for the worse. At the same time as cutting official borrowing costs, the ECB also expanded its armoury substantially by agreeing to match in full eurozone banks’ demand for liquidity for periods of up to six months.
Although such steps have attracted less attention, ECB policymakers argue the effects on the recession-hit eurozone economy have been similar to “quantitative” or “credit” easing measures unveiled by the Bank of England and US Federal Reserve. The decision to offer funds for one-year – announced in May and dubbed by some economists a “stimulus by stealth” - marked a further escalation of the ECB’s offensive. Unlike in previous operations, however, banks appear not to have held back in the expectation that interest rates will subsequently fall. Creating an additional incentive, the ECB reserved the right in future one-year operations to charge an interest rate above its main policy rate.
Confirmation that the ECB was in a “wait and see” mode as regards future interest rate decisions was provided by José Manuel González-Páramo, an ECB executive board member. He told a Spanish newspaper: “Let’s wait and see how the latest measures work. We did not decide that 1 per cent was the lowest (interest rate) level imaginable in any scenario, but we do think that it is the appropriate level given the information that we have currently available.”
However the Paris-based Organisation for Economic Co-operation and Development argued in its latest report that the ECB still had scope to cut official borrowing costs. The pace at which the eurozone economy was contracting decelerated sharply in the second quarter, according to latest survey evidence. But the ECB and other economists have been wary about forecasting any early return to growth.
Japan Export Slump Deepens, Casting Doubt on Recovery
Japan’s export slump deepened in May, casting doubt on the nation’s growth prospects as the economy struggles to emerge from its worst postwar recession. Shipments abroad dropped 40.9 percent from a year earlier, more than April’s 39.1 percent decline, the Finance Ministry said today in Tokyo. The median estimate of economists surveyed was for a 39.3 percent decrease. From a month earlier, exports fell 0.3 percent, the first deterioration since February.
Declines in shipments to Asia accelerated for the first time since January, damping hopes that demand from the region will spur a recovery in the world’s second-largest economy. A worldwide stock market rally stalled this month on concern that the global recession will deepen. “Final demand just isn’t picking up and it’s still hard to expect a very strong economic recovery,” said Azusa Kato, an economist at BNP Paribas in Tokyo. Kato said the economy will “barely expand” in 2010 once the effect of Japan’s own economic stimulus measures fades.
The yen traded at 95.38 per dollar at 12:05 p.m. from 95.25 before the report and a three-week high yesterday. The Topix stock index fell 0.2 percent, extending its decline to 5.4 percent since reaching a seven-month peak on June 12. The MSCI World Index has lost 3.1 percent this month. Steel, autos and semiconductors led the slump. Shipments to China, Japan’s biggest trading partner, fell 29.7 percent, more than April’s 25.9 percent. Exports to Asia slid 35.5 percent from 33.4 percent a month earlier. China’s 4 trillion yuan ($585 billion) in stimulus measures haven’t been enough to offset sales declines in the U.S. and Europe.
Hitachi Construction Machinery Co. said this month that sales in China haven’t improved as much as the company had anticipated. The world market for digging equipment will contract by more than a third in the first half of the business year and rebound only 6 percent in the second half, according to company President Michijiro Kikawa. Shipments to the U.S. fell 45.4 percent in May after dropping 46.3 percent in April, the ministry said. Exports to Europe slid 45.4 percent from 45.3 percent. The World Bank this week downgraded its forecast for global growth, saying the world economy will shrink 2.9 percent this year, worse than the 1.7 contraction predicted in March.
Toyota Motor Corp. said yesterday the outlook for car sales in the U.S. remains uncertain. The U.S. economy is forecast to shrink at an annual 2 percent pace in the current quarter and grow 0.5 percent in the next three months. The Bank of Japan and the government both said last week that the recession is moderating because companies are increasing production to replenish stockpiles. That rebound in output may wane in the absence of a pickup in exports.
“It’s been widely considered that falling inventories overseas have been supporting Japan’s exports,” said Kato at BNP Paribas. “Even if exports improve in June, they would be around 80 percent of their peak, making it difficult for the economy to expand.” Central bank Governor Masaaki Shirakawa said this month he’s “cautious” about the prospects for a sustained recovery. Analysts surveyed by Bloomberg predict Japan will resume growing in the three months to June 30 after last quarter’s record annualized 14.2 percent contraction. They said growth will peak at 2 percent next quarter and grind to a halt in 2010.
Imports slid 42.4 percent from a year earlier, and the trade surplus narrowed 12.1 percent to 299.8 billion yen ($3.1 billion), the Finance Ministry said. “With the world economy in recession it’s a tough story for Japan,” said Jan Lambregts, head of financial markets research at Rabobank International in Hong Kong. “The U.S., the euro zone, the rest of Asia have to recover, and then Japan can benefit.”
Bank governor Mervyn King says scale of UK deficit is 'truly extraordinary'
Mervyn King, the Bank of England Governor, warned about the size of the UK deficit and of a 'long hard slog' to recovery as he took questions on the May Inflation Report from Treasury Select Committee on Wednesday. Here are some highlights.
KING ON FISCAL POLICY
"The scale of the deficit is truly extraordinary. 12.5pc of GDP is not something that anybody would have anticipated even a year or two ago and this reflects the scale of the global downturn. But it also reflects the fact that we came into this crisis with fiscal policy itself on a path that wasn't itself sustainable and a correction was needed. The speed of which the fiscal stimulus should be withdrawn has to depend on the state of the eocnomy. There is no point in presenting a profile for the reduction of deficits that is independent of the state of the economy. There will certainly need to be a plan for the lifetime of the next parliament, contingent on the state of the economy, to show how those deficits will be brought down if the economy recovers to reach levels of deficits below those which were shown in the budget figures. There is just as good a chance that the picture will turn out to be better than was painted in those single numbers as it being worse."
KING ON REACHING ABOVE TREND GROWTH
"I'm sure at some point we'll do it. There has to be a risk that it will be a long, hard slog because of the difficulties in the banking sector. I feel more uncertain now than ever. This is a pattern of recession that we've not seen since the 1930s. Not pretending to be able to foresee the future when it's so uncertain is important."
KING ON RISK OF WITHDRAWING STIMULUS
"If you withdraw stimulus too quickly, you run the risk that the dowtnurn will resume. Equally of course, we need to be very careful not to allow the stimulus to reach the point at which inflation takes off. There is a balance to be struck, this balance is not a theoritecial issue it's a practical issue."
KING ON RECOVERY/REFORM
"To ensure a sustainable recovery and prevent a repetition of the crisis we must reform the international monetary system. The United Kingdom and other deficit countries will now be aiming at more sustainable levels of domestic demand. Unless domestic demand in the surplus countries is expanded, overall world demand will remain persistently sluggish. The fall in sterling that we have experienced since the crisis began would mitigate but not wholly offset a weak world outlook."
KING ON EFFECT OF QUANTITATIVE EASING
"The first objective of the asset purchase programme is to inject additional money directly into the economy. The little evidence we do have seems to be positive. Growth of broad money has picked up to a more normal level."
Citi Unit Halts Mortgage Applications on Missing Data
Citigroup Inc. suspended loan applications at a unit that produced half of its $115 billion in mortgages last year after a review found that some property appraisals and income-verification documents were missing. The correspondent division, which buys loans from banks and independent mortgage firms, stopped accepting new loans at 5 p.m. yesterday and will restart July 6, Citigroup said in a June 22 letter to clients. The New York-based company said it will use the time to change procedures and fix the omissions.
“There remain key areas that fall short of our quality- control process,” according to the letter, signed by Brad Brunts, a managing director at the bank’s CitiMortgage division. “We ask you to review your processes and join us in this effort to collectively address these areas of concern.” Citigroup has been overhauling its mortgage business since January, when Chief Executive Officer Vikram Pandit shifted it into a “non-core” group called Citi Holdings along with other businesses tagged for sale, wind-down or restructuring. The bank lost a record $28 billion in 2008, much of it tied to mortgage- bond writedowns and costs to cover soured home loans amid the global credit crunch.
The bank accepted $45 billion of bailout funds from the U.S. Treasury and has increased employees’ pay to keep them from leaving. Citigroup will raise base salaries by as much as 50 percent to help compensate for a reduction in annual bonuses, a person familiar with the plan said yesterday. The bank climbed 1.7 percent to $3.06 as of 10:32 a.m. in New York Stock Exchange composite trading today; the shares have tumbled more than 90 percent since the end of 2006. New-home purchases dropped 0.6 percent in May and the median sales price declined 3.4 percent, the Commerce Department said today.
The new procedures in the correspondent unit follow a series of steps Citigroup’s mortgage business took over the past two years to address lapses in documentation or underwriting standards. The business is run by Sanjiv Das, who reports to Citi Holdings CEO Mike Corbat. In October, Citigroup cut off all but 1,000 of the 9,500 mortgage brokers in its network for selling the bank loans of poor quality, or in insufficient volume to be profitable. The company also stopped making second-lien mortgages through third parties. Regulators blamed practices at independent lenders last year for driving mortgage default rates to record highs.
Mark Rodgers, a spokesman for the bank, confirmed the suspension, adding that quality-control practices at the correspondent unit are reviewed on an “ongoing basis, and we have identified areas of improvement.” He declined to comment on the timing or specifics of the review, or to say how many loans had missing documentation. As of Dec. 31, the bank had $73 billion of mortgages on its books that had been originated through the correspondent channel. Loan purchases already in the works will continue, according to the letter to clients.
According to the June 22 letter, the review identified “valuation concerns” where “appraisal documentation is missing or incomplete,” or where property-assessment methods were “insufficient/lacking.” Other missing information included employment confirmations, phone numbers, credit reports and rent verification, the letter said. The review also found “income calculation errors.” The suspension of correspondent lending is “a bold step” that may frustrate Citigroup’s mortgage-banking partners and put them on notice that the company will no longer tolerate incomplete loan submissions, said David Lykken, managing partner at consultant Mortgage Banking Solutions in Austin, Texas.
“You need to have a hard stop,” Lykken said. “It is better to pull people off the line, and have a thorough re- education of what goes into a loan, so they can come back and do this the right way.” Independent mortgage bankers trying to unload their loans during the suspension will have to turn to Citigroup’s competitors, Lykken said. The correspondent unit was Citigroup’s biggest producer of mortgages last year with $58.5 billion of originations, according to industry publication Inside Mortgage Finance. Other channels include retail -- where the bank deals directly with borrowers through branches or call centers -- and the network of mortgage brokers.
JPMorgan Chase & Co. was the biggest correspondent lender last year with $98.7 billion of originations, followed by Wells Fargo & Co. with $80.5 billion and Countrywide Financial Corp. with $59 billion, according to Inside Mortgage Finance. Bank of America Corp., which bought Countrywide last year, ranked fifth with $40.6 billion. Even before Pandit moved the mortgage business into Citi Holdings, Citigroup had determined that loans coming from the correspondent channel had higher delinquency rates than those from retail, according to the bank’s 2008 annual report, filed in February. The bank later terminated “an undisclosed number of correspondent mortgage banks,” the annual report said.
The letter said the bank remains “committed” to the correspondent business and wants to “continue to be a long-term recognized industry investor.” The latter statement may address industry speculation that Citigroup will exit the mortgage business, which was kindled by Pandit’s decision to shift it to Citi Holdings, Lykken said. “This is a positive sign of Citi’s commitment to correspondent channel,” Lykken said. “They want to improve their process, so they can remain an active player.”
The documentation improvements may reduce the number of bad mortgages Citigroup forces its customers to buy back, said Scott Stern, CEO of mortgage-banking cooperative Lenders One in St. Louis. Most mortgages are sold with warranties guaranteeing their performance. “If the end result of these actions is a faster loan- acquisition process and fewer loan repurchases for mortgage companies, it will definitely have been a good decision,” Stern said.
Citigroup Has a Plan to Fatten Salaries
After all those losses and bailouts, rank-and-file employees of Citigroup are getting some good news: their salaries are going up. The troubled banking giant, which to many symbolizes the troubles in the nation’s financial industry, intends to raise workers’ base salaries by as much as 50 percent this year to offset smaller annual bonuses, according to people with direct knowledge of the plan.
The shift means that most Citigroup employees will make as much money as they did in 2008, although some might earn more and others less. The company also plans to award millions of new stock options to employees in an effort to retain workers and neutralize a precipitous drop in the value of their stock holdings. Like Citigroup, financial companies, like Bank of America and Morgan Stanley, are raising employees’ base salaries to try to shift attention away from bonuses and curb excessive risk-taking. So are banks like UBS and other European competitors.
The Citigroup proposals, discussed internally this week, present a crucial test for the Obama administration, which has vowed to rein in runaway compensation at companies that have received large taxpayer-financed bailouts. Citigroup has gotten not one but two rescues from Washington. Soon the government will assume a 34 percent stake in the company, whose share price has plunged nearly 84 percent in the last year.
Despite Washington’s new role at Citigroup, and public anger over big paydays on Wall Street, administration officials have little power to prevent the company and others in the industry from raising salaries for rank-and-file employees. Kenneth R. Feinberg, the administration’s new “pay czar,” has the authority to set compensation for only the top 100 employees at troubled companies. The rest — which at Citigroup, means fewer than 300,000 people — can be paid as executives see fit, provided any increase does not rank them among the 100 most highly paid workers.
Outsize pay on Wall Street, particularly the industry’s bonus culture, is widely seen as having encouraged the risk-taking that led to the gravest financial crisis since the Depression. But industrywide, total compensation is expected to rise 20 to 30 percent this year, approximately to the levels of 2005, before the crisis, according to Johnson Associates, a compensation consulting firm. Total industry pay would still be below the record levels of 2007, but only a bit. “You can say it is outrageous,” said Alan Johnson, the president of the firm. “But maybe it’s a little like the canary in the mine, and you say that things are getting better.”
Indeed, despite the simmering anger over Wall Street pay, some of the 10 big banks that repaid their federal aid this month — a big step toward disentangling themselves from the government — are gearing up to pay outsize bonuses. For many, profits are up, despite the troubled economy. On Monday, Goldman Sachs, which returned $10 billion of bailout funds, denied reports that it planned to pay out the highest bonuses in its 140-year history.
Mr. Feinberg, the special master for compensation, is the person who ensures that companies receiving federal bailout money are abiding by executive pay guidelines. This week, Mr. Feinberg, who oversaw the federal government’s compensation fund for victims of the Sept. 11, 2001, terrorist attacks, held introductory meetings with Citigroup executives and their counterparts at several other companies that have received two federal bailouts. He will start reviewing pay packages for the 25 highest-paid employees, as well as compensation formulas for the next 75, in the next two months. He declined to comment on Tuesday.
For months, Citigroup executives have sought guidance from the Treasury Department about how to alter compensation. But after reviewing the new rules, the bank determined it did not need Mr. Feinberg or other government officials to sign off on pay for the rank and file. While Mr. Feinberg can request information on the pay polices at financial companies that have received two federal bailouts, the companies can reject his guidance.
Citigroup executives are so eager to keep employees from fleeing, that in some cases, they are offering them guaranteed pay contracts. Managers began notifying bank employees of the proposed changes this week. They could take effect shortly. For some Citigroup investment bankers and traders, the changes could mean salary increases of as much as 50 percent, depending on their position. Legal and risk management employees, as well as those in the credit card and consumer banking units, whose pay is typically skewed toward salary, rather than bonuses, are expected to receive smaller increases.
Citigroup executives said the changes were aimed at retaining employees. Some Citigroup workers have already left for small, boutique investment banks or large rivals that are not so beholden to the government. Citigroup officials declined to discuss the issue on the record, given its sensitive nature. But they said that the changes would bring the bank’s compensation plan in line with the widespread view on Wall Street that bonuses were not one-time payouts, but rather a form of deferred salary. They said the new system would let them adjust bonuses more sharply to reflect employees’ performance.
Stephen Cohen, a Citigroup spokesman, said that any changes would be intended to adjust the balance between salaries, which are fixed, and bonuses, which vary from year to year. Citigroup also plans to introduce a new stock option program later this year. Under the plan, it will award employees one stock option for every share of restricted stock they have accumulated. The program could open the floodgates for the release of tens of millions of stock options that could be cashed out over the next three years. It is unclear what the strike price will be. But the hope is that the options program will give employees another incentive to stay despite offers from rivals.
Obama Bulks Up 'Too Big to Fail' With Steroids
Back when Bob Rubin and Larry Summers were running Treasury and financial crises were confined to developing countries, international-government types would opine about revamping the “global financial architecture.” One attempt at architectural redesign and integration was Basel II, a standardized system for assessing banks’ capital adequacy based on underlying risks. Banks deftly circumvented the regulation by shifting risky assets off the balance sheet.
Next? The Obama administration’s architects went back to the drawing board and last week produced a blueprint for regulating financial institutions. One controversial aspect of the plan is the creation of a systemic risk regulator, the Federal Reserve, with the power to oversee any financial firm, not just a bank holding company, “whose combination of size, leverage and interconnectedness could pose a threat to financial stability if it failed.”
In other words, the same folks who missed, or did nothing to prevent, the worst crisis since the Great Depression will definitely, absolutely, positively be able to anticipate the next one. Uh-huh. It gets worse. Instead of eliminating the doctrine of “too big to fail,” which encourages risky behavior because of perceived government backing, the Obama plan defines, institutionalizes and expands on it. “All systemically important companies will be subject to enhanced regulation,” says Peter Wallison, senior fellow at the American Enterprise Institute, a conservative Washington think tank. “What could that possibly mean? It means they are too big to fail.”
Previously the determination of who was and wasn’t TBTF was in the eye of the beholder: It had to be inferred. This past year, the federal government took the guesswork out by designating Fannie Mae and Freddie Mac, 19 of the biggest banks, two car companies and one insurance company acting like a hedge fund as charter members. “We need to get rid of too big to fail,” says Allan Meltzer, professor of political economy at Carnegie Mellon University in Pittsburgh. “It perpetuates a system where bankers make profits and the public takes losses. We want to put responsibility back on bankers.”
Bigness wouldn’t be the only prerequisite for failure exemption. The 88-page White Paper released last week expands the standard to include too leveraged and too interconnected without ever quantifying “too,” Wallison says. Institutions that are perceived as TBTF can borrow at lower interest rates, using their funding advantage to muscle out smaller lenders. No wonder small banks are voicing reservations about the plan, which has the potential “to destroy competition in every corner of the economy where you identify too big to fail,” Wallison says.
Some economists criticized Obama’s “New Foundation: Rebuilding Financial Supervision and Regulation” for being built on shaky ground. The administration’s analysis of the roots of the crisis reads “as if the problems were caused by unregulated firms,” writes Arnold Kling, a member of the financial markets working group at George Mason University’s Mercatus Center, in a June 17 blog post. “The holders of credit risk were regulated institutions, especially Fannie Mae, Freddie Mac and the banks. They took on excessive risks right under the noses of the regulators.”
Proper diagnosis is key to implementing a treatment plan. Without it, the effort to re-regulate the financial system will be a politicized effort that will cause more harm than good. Speaking of Fannie Mae and Freddie Mac, Meltzer says the other main problem with the Obama plan is its failure to deal with the two government-sponsored (now owned) enterprises. “We should take Fannie and Freddie and close them down, make Congress put the subsidies on the budget and eliminate their function,” he says.
If Congress wants to subsidize low-income housing, fine. Write that subsidy into the budget so it’s transparent. In addition to the proposal for a systemic risk regulator, the plan would eliminate the Office of Thrift Supervision, create an agency to protect consumers from abusive lending practices, regulate over-the-counter derivatives and curtail the Fed’s emergency lending powers. Loan originators and securitizers would be required to retain 5 percent of their pooled assets, creating a modest incentive to perform due diligence.
“I’d make the retention 20 percent,” says Bush administration Treasury Secretary Paul O’Neill, who would mandate a 20 percent down payment on every mortgage, a relic from another era. “Why not ensure that housing finance never gets us into trouble again,” especially since it was lax mortgage underwriting standards that brought the U.S. and world economy to its knees? Answer: Because it’s politically unpopular.
Already politicians are appealing to Fannie and Freddie to relax standards on mortgages for new condominiums, according to yesterday’s Wall Street Journal. House Financial Services Committee Chairman Barney Frank, Democrat of Massachusetts and long-time enabler of the GSEs, wrote to the chief executives of both companies asking them to lighten up on recently tightened terms, the Journal says. You can see where this is going, and Congress hasn’t even had a chance to get its fingerprints on the White Paper.
Elizabeth Warren: Banking "broken," consumers need help
The outspoken head of a U.S. Congressional watchdog panel will strongly urge lawmakers on Wednesday to set up a new government agency to protect consumers from "tricks and traps" set by banks. President Barack Obama has called for creating an independent financial products agency to oversee consumer lending as part of his sweeping proposal to overhaul the U.S. financial regulatory system.
"We can help fix the broken credit market. And I can sum it up in four words: Consumer Financial Protection Agency," said Elizabeth Warren, chairman of the Congressional Oversight Panel of the Troubled Asset Relief Program, in prepared remarks. Warren, who is a professor at Harvard Law School, will be the marquee witness at a House of Representatives committee hearing on Wednesday looking at a key provision of Obama's broad plan to drag the aging U.S. financial regulatory system into the 21st century.
The provision to establish a financial protection agency for consumers "will be carried out," Senator Jack Reed, chairman of the Senate securities subcommittee, said in an interview with Reuters Television on Tuesday.
"Definitely you have to have a consumer protection agency," he said, echoing vows made in recent days by Obama and by Senate Banking Committee Chairman Christopher Dodd on a proposal that is meeting more criticism from business interests than perhaps any other part of the Obama plan.
Congress is only beginning to delve deeply into the plan, a far-reaching response to the severe banking and capital markets crisis that has rocked economies around the world. The European Union is eyeing similar reforms.
One issue in the crisis was the enormous debt shouldered by Americans in a real estate bubble fueled by subprime mortgages that many borrowers could not afford and did not understand, a factor that contributed to a huge spike in foreclosures that has helped drag the United States into recession. Ending such lending practices is a key goal of the reforms being proposed by Obama and backed by congressional Democrats.
Warren, in her remarks to be given before the House committee led by Democratic Representative Barney Frank, cited studies and said that most consumers don't understand the terms underlying credit cards, mortgages, payday loans, tax refund anticipation loans and credit scores. "The broken credit market has put American taxpayers on the hook for billions in subsidies and trillions in guarantees to shore up our largest financial institutions. ... If we do not fix this, we will be hurt again and again," she said. A financial protection agency would help consumers make better decisions for themselves, she said.
Warren said that banking has changed over the years, from an old model that she called "simple and effective: consumers shopped around for products and terms, and lenders evaluated the creditworthiness of potential borrowers before making loans. "Today, the business model has shifted. Giant lenders 'compete' for business by talking about nominal interest rates, free gifts and warm feelings, but the fine print hides the things that really rake in the cash. Today's business model is about making money through tricks and traps," she said. The proposed new watchdog, however, is already drawing sharp criticism.
The Obama plan "would create a very powerful agency that could make it much more expensive for banks to offer products and services to consumers," said financial services policy analyst Jaret Seiberg at research firm Concept Capital. "The chairman of the (agency) would be vested with tremendous power and few checks or balances. This should be especially worrisome to the banking sector as we would expect Professor Elizabeth Warren ... to get the job."
Representative Bill Delahunt has introduced legislation in the House to create a "Financial Product Safety Commission." He said in prepared remarks that it was originally Warren's idea. It would "review financial products for safety; modify dangerous products before they hit the markets; establish guidelines for consumer disclosure; and collect and report data about the uses of different consumer loans," Delahunt said. Some current regulators have said they fear separating bank safety and soundness oversight from consumer protection.
Ellen Seidman, a former bank regulator who is now a senior fellow at the New America Foundation, a think tank, expressed support for the new agency in her prepared remarks for the committee. But she said bank regulators should retain consumer protection responsibilities. "The bank regulators, given the proper guidance from Congress and the will to act, are quite capable of effectively enforcing consumer protection laws," Seidman said.
A leading bank industry group said in its prepared remarks that new rules and examinations from the proposed safety agency would be costly, especially for smaller banks, and would not likely result in better protections for consumers. Edward Yingling, president of the American Bankers Association, said the agency would contradict the goal of fashioning an integrated, comprehensive regulatory system. "Simply put, it is a mistake to separate the regulation of an institution from the regulation of its products," he said.
Obama’s Financial Watchdog Is Toothless Proposal
After an era of consumer financial abuses, how would you oversee the most damaging industries? The Obama administration’s proposed consumer financial watchdog overhaul avoids confronting the most frequent offenders while under-regulating a key industry. Many of the products sold by banks, brokers and insurance agents have fallen through the cracks of the current regulatory regime. The administration’s proposed creation of the Consumer Financial Protection Agency may not do any better in policing these troubling investments.
What does Obama’s 88-page plan, for example, suggest to curb the sale of highly illiquid auction-rate securities, which were sold as if they were safe money-market funds? State securities agencies largely took the lead on returning more than $60 billion to investors, not the U.S. Securities and Exchange Commission or banking regulators. Consumer truth-in-labeling laws should apply to financial products, yet there was no mention of this kind of disclosure in the overhaul proposal.
If consumers can see warning stickers for step ladders, baby strollers and laptop-computer batteries, the government can mandate plain-English disclosure for financial products. Sample Warning: “This product may lose as much as 60 percent of its value!” At present, snack food has better labeling. It’s a shame the administration’s white paper didn’t specifically name some of the most egregious investor issues it should be trying to police. My short list would include:
- Why were parents in certain college savings plans hit with huge losses by bond-fund managers speculating in high-risk mortgage derivatives last year? Right now, so-called 529 plans are overpriced and loosely regulated by states -- who often get a cut of administrative fees -- and the Municipal Securities Rulemaking Board, which polices municipal bonds. State authorities aren’t up to the task.
- Who is watching over 401(k)-type retirement plans in Obama’s proposed agency? Last year, investors lost as much as 41 percent in misleadingly labeled target-date maturity funds, vehicles that investors thought would lock in principal by a certain date. The SEC, Congress and the U.S. Labor Department have been unable to provide clear risk disclosure and rein in excessive fees.
- What about insurance-product abuses? Federal and state regulators have been inadequately supervising the aggressive marketing of variable annuities for years. Several times a year I get a call or see a story about some 80-year-old who had been sold these high-commission products. One strong agency should take the lead on this perennial problem.
Also in doubt is the essential need to uniformly supervise all financial consultants and planners. Right now, regulation is a mishmash. Investment advisers register with the SEC. Brokers are somewhat supervised by the states and industry-led Financial Industry Regulatory Authority. Anyone can claim to be a financial planner these days. The overhaul proposal dances around the issue of making broker-advisers more accountable, citing a need to establish a tougher “fiduciary duty” for broker-dealers.
That means brokers could be sued and wouldn’t be subject to loose “suitability standards” that force aggrieved investors into industry-dominated mandatory arbitration. It’s the fiduciary standard that should be required for everyone who gives financial advice, although the administration’s framework doesn’t say that. What about insurance companies that are allowed to sell investments, policies, manage money and run potentially catastrophic portfolios in derivatives? Remember American International Group Inc.?
It’s regrettable the administration proposes an “Office of National Insurance” within the Treasury Department for just “monitoring” this 135-year-old, almost $6 trillion industry. The administration can do better than that. If it wants supervision with some teeth, it will need a strong national regulator that won’t simply duplicate spotty state authorities. It’s a step in the right direction, though, that a new consumer agency will supervise mortgages, savings and other banking products.
Yet Wall Street and the banking industry hate the idea of strengthening this porous system to make it more pro-investor and have already begun to fight the administration’s reform attempts. That means you still have to be your own cop in vetting brokers, advisers and insurance agents. The proposal that the administration is floating will be reworked before it’s crafted into legislation that the president has urged Congress to pass before the end of the year. But as it reads now, the consumer watchdog they are proposing won’t hunt, bark or bite. It can barely walk.
Reform of regulation has to start by altering incentives
by Martin Wolf
Proposals for reform of financial regulation are now everywhere. The most significant have come from the US, where President Barack Obama’s administration last week put forward a comprehensive, albeit timid, set of ideas. But will such proposals make the system less crisis-prone? My answer is, no. The reason for my pessimism is that the crisis has exacerbated the sector’s weaknesses. It is unlikely that envisaged reforms will offset this danger. At the heart of the financial industry are highly leveraged businesses.
Their central activity is creating and trading assets of uncertain value, while their liabilities are, as we have been reminded, guaranteed by the state. This is a licence to gamble with taxpayers’ money. The mystery is that crises erupt so rarely. The place to start is with the core of modern capitalism: the limited liability, joint-stock company. Big commercial banks were among the most important products of the limited liability revolution. But banks are special sorts of businesses: for them, debt is more than a means of doing business; it is their business. Thus, limited liability is likely to have an exceptionally big impact on their behaviour.
Lucian Bebchuk and Holger Spamann of the Harvard Law School make the big point in an excellent recent paper.* Its focus is on the incentives affecting management. These are hugely important. Still more important, however, is why a limited liability bank, run in the interests of shareholders, is so risky. In a highly leveraged limited liability business, shareholders will rationally take excessive risks, since they enjoy all the upside but their downside is capped: they cannot lose more than their equity stake, however much the bank loses.
In contemporary banks, leverage of 30 to one is normal. Higher leverage is not rare. As the authors argue, “leveraged bank shareholders have an incentive to increase the volatility of bank assets”. Think of two business models with the same expected returns: in one these returns are sure and steady; in the other the outcome consists of lengthy periods of high returns and the occasional catastrophic loss. Rational shareholders will prefer the latter. This is what one sees: high equity returns, by the standards of other established businesses, and occasional wipe-outs.
Profs Bebchuk and Spamann add that four features of the modern financial system make the situation even worse: first, the capital of banks is itself partly funded by debt; second, the role of bank holding companies may further increase the incentives of shareholders to underplay risk; third, managers are rewarded for aligning their interests with those of shareholders; and, fourth, some of the ways managers are rewarded – options, for example – are themselves a geared play on rewards to shareholders. So managers have an even bigger economic interest in “going for broke” or “betting the bank” than shareholders. As the paper notes, the fact that some managers lost a great deal of money does not demonstrate they were foolish to make these bets, since their upside was so huge.
A solution seems evident: let creditors lose. Rational creditors would then charge a premium for lending to higher-risk operations, leading to lower levels of leverage. One objection is that creditors may be ill-informed about the risks being run by banks they are lending to. But there is a more forceful objection: many creditors are protected by insurance backed by governments. Such insurance is motivated by the importance of financial institutions as sources of credit, on the asset side, and suppliers of money, on the liability side. As a result, creditors have little interest in the quality of a bank’s assets or in its strategy. They appear to have lent to a bank. In reality, they have lent to the state.
The big lesson of the current crisis is just how far such insurance may go in the case of institutions deemed too big or interconnected to fail. Big banks rarely get into trouble in isolation: they often make very similar errors; moreover, the failure of one impairs the actual (or perceived) solvency of others. Thus, creditors are most at risk in a systemic crisis. But a systemic crisis is precisely when governments feel compelled to come to the rescue, as they did at the end of last year. According to the International Monetary Fund’s latest Global Financial Stability Report, support offered by the US, UK and eurozone central banks and governments has amounted to $9,000bn (€6,400bn, £5,500bn), of which $4,500bn are guarantees. The balance sheet of the state was put behind the banks.
This does not mean creditors bear no risk at all. But their risk is attenuated. The well-known solution is to regulate such insured institutions very tightly. But an enormous part of what banks did in the early part of this decade – the off-balance-sheet vehicles, the derivatives and the “shadow banking system” itself – was to find a way round regulation. The obvious question is whether it will be “different this time”. Sensible people must doubt it. Indeed, it must be particularly unlikely when the capitalisation of banks is so small. This is the time to go for broke.
In a speech delivered just last week, Mervyn King, governor of the Bank of England, made clear why finding a better approach matters so much: “The costs of this crisis are not to be measured simply in terms of its impact on public finances, the destruction of wealth and the number of jobs lost. They are also to be seen in the lost trust in the financial sector among other parts of our economy ... ‘My word is my bond’ are old words. ‘My word is my CDO-squared’ will never catch on.” Such a crisis is not only the result of a rational response to incentives. Folly and ignorance play a part.
Nor do I believe that bubbles and crises can be eliminated from capitalism. Yet it is hard to believe that the risks being run by huge institutions had nothing to do with incentives. The unpleasant truth is that, today, the incentive to behave in this risky way is, if anything, even bigger than it was before the crisis. Regulatory reform cannot end with incentives. But it has to start from incentives. A business that is too big to fail cannot be run in the interests of shareholders, since it is no longer part of the market. Either it must be possible to close it down or it has to be run in a different way. It is as simple – and brutal – as that.
Too big to fail is too big
by Willem Buiter
The too big to fail problem has been central to the degeneration and corruption of the financial system in the north Atlantic region over the past two decades. The ‘too large to fail’ category is sometimes extended to become the ‘too big to fail’, ‘too interconnected to fail’, ‘too complex to fail’ and ‘too international’ to fail problem, but the real issue is size. The real issue is size. Even if a financial business is highly interconnected, that is, if its total exposure to the rest of the world and the exposure of the rest of the world to the financial entity are complex and far-reaching, it can still be allowed to fail if the total amounts involved are small. A complex but small business is no threat to systemic stability; neither is a highly international but small business. Size is the core of the problem; the other dimensions (interconnectedness, complexity and international linkages) only matter (and indeed worsen the instability problem) if the institution in question is big. So how do we prevent banks and other financial businesses from becoming too large to fail?
Remedies for too big to fail
(1) Become too big to save
In a few cases, banks have been not just too big to fail, but also too big to save. The fiscal spare capacity of the state that ultimately backs the financial institutions deemed too big to fail turned out to be insufficient to save them. This happened in Iceland in September-October 2008. The four international banks of Iceland now have all defaulted on their debts. It could happen in other places. Anne Sibert and I have pointed to the dangers of the ‘inconsistent quartet’: a small open economy with a large internationally exposed sector, its own ‘small’ non-global reserve currency and limited fiscal spare capacity. Apart from Iceland, which imploded, this category includes Switzerland and possibly the UK. Ireland, the Netherlands and Belgium have 3 of the four inconsistent characteristics. But for their membership in the Euro Area, their banking systems might have been toast already. For the US banks and most Euro Area banks, the banks top managers and boards know, however, that they are too big to fail but not too big to save. And they play that card for all it is worth to extract the maximum amount of resources from the hapless tax payer.
(2) Restore narrow banking or public utility banking
‘Public utility banking’ with just retail deposits on the liability side and with reserves, sovereign debt instruments and bank loans (secured and unsecured) on the asset side would take care of the retail payment, clearing and settlement system and deposit banking. Such narrow banking would represent an extreme version of Glass-Steagall approach. There would be deposit insurance and, should that fail, a lender of last resort and market maker of last resort. These tightly regulated institutions would not be able to engage in other banking and financial activities, and other financial institutions would not be able to take deposits withdrawable on demand or economically equivalent instruments. These public utility banks could be publicly owned or privately owned, or could be managed through mutual arrangements (like the UK building societies or the Dutch Rabo Bank) or through cooperatives. Where the public utility bank is publicly owned, I would hope its management would be contracted out to a properly incentivised private concessionaire. Civil servants make lousy loan officer.
From the horror stories that have come out of at least five of the seven German Landesbanken, it is clear that public ownership and control is no guarantee for sound banking. They were brought down by two developments. The old and familiar problem was that they were pushed by cash-strapped Länder governments to engage in politically popular but financially non-viable regional projects. The second problem was that, far from remaining narrow banks, these Landesbanken engaged, sometimes through off-balance sheet vehicles, in increasingly reckless investment bank behaviour, including investing in financial instruments they did not understand. The problems of the German Landesbanken are mirrored in the disastrous shape many of the Spanish Cajas, mutually owned, co-operatively owned or owned or controlled by local or regional authorities, find themselves in. Narrow banking or public utility banking would, be a key part of a safer and less morally hazardous banking system.
(3) Create mono-product central counterparties and providers of custodial services, central wholesale and securities payment, clearing and settlement platforms
We cannot have essential financial infrastructure services provided by unregulated or lightly regulated profit-seeking private enterprises that may be engaged in a variety of other financial activities, many of them high risk, as well. The entities that provide these services have to be treated and regulated as public utilities. This includes the wholesale (interbank) payments, clearing and settlement systems (TARGET, in the Euro Area). It also includes the securities clearing and settlement systems and the custodial services essential to their performance (TARGET2 Securities in the Euro Area). The tripartite and quadripartite repo system is included.
If these services are to continue to be privately provided, the firms engaged in their provision should be strictly regulated and restricted to perform just the regulated tasks. There should be also be redundancy: for operational security reasons, there should be at least two physically, administratively and legally separate and independent providers of the entire suite of systemically essential services. There is no reason why the central bank would provide any of these services, although it could.
Whatever entity provides these services should have open-ended and uncapped access to central bank liquidity, guaranteed by the Treasury. What constitutes essential financial infrastructure services will change over time. In view of the problems created by the opaque over-the-counter markets in certain kinds of derivatives (e.g. credit default swaps (CDS)), centralized trading platforms, perhaps with a market maker of last resort, and with transparent clearing, settlement and custodial services-providing rules and arrangements will have to be created for many of these derivatives. These platforms should be viewed and regulated as public utilities.
(4) Keep a lid on the size of investment banks
Let’s call all other activities currently undertaken by the banking sector and the shadow banking sector will be called investment banking activities. It might seem that, since the products, services and instruments created exclusively by the investment banking sector are not systemically important, these investment banks could be left to play by the normal rules of the market game, with little if any regulation. Unfortunately, this is not the case. Financial instruments that are not systemically important if a few trillion US dollars worth of them are outstanding, become systemically important when, as in the case of CDS at their peak, $60 trillion worth of gross notional exposure is outstanding. Pure investment banks, even if they have been stripped of their ‘infrastructure services providing (including counterparty) roles, can be too large to fail. What is to be done about them.
(5) Tax bank size
When size creates externalities, do what you would do with any negative externality: tax it. The other way to limit size is to tax size. This can be done through capital requirements that are progressive in the size of the business (as measured by value added, the size of the balance sheet or some other metric). Such measures for preventing the New Darwinism of the survival of the fattest and the politically best connected should be distinguished from regulatory interventions based on the narrow leverage ratio aimed at regulating risk (regardless of size, except for a de minimis lower limit).
(6) Use competition policy
Strict and aggressive competition policy is another way to reduce size. Large banks can be broken up in a variety of ways (vertically, that is, by activities or products) or horizontally, that is, by splitting a given activity or the supply of a given product of service among several independent legal entities. The crisis and contraction are delivering the opposite outcome. There are fewer banks and market concentration is increasing everywhere. In the UK, competition among banks in the high street is going to be materially diminished by the acquisition of HBOS by Lloyds-TSB. With Bear Stearns, Lehman Brothers and Merrill Lynch gone as independent investment banks, concentration and monopoly power in the investment banking market has exploded.
Are mega-banks necessary for efficiency?
Would there be significant efficiency losses as a result of breaking up banks and taxing bank size? What would be the social cost of taxing size in banking and other financial businesses and of breaking up banks? Why do banks and other financial enterprises become too big to fail? I believe there are four reasons
(1) The exploitation of monopoly power (market power).
(2) The exploitation of ‘synergies of conflict of interest’.
(3) The exploitation of economies of scale and economies of scope.
(4) The joys of being too big to fail and the implicit subsidy provided by the tax payer guaranteeing the bank against default and insolvency.
The pursuit of the benefits of subsidized liquidity and solvency support from the state clearly makes sense for the bank’s top management and board, for shareholders and for unsecured creditors: being too big, too interconnected, too complex and too international to fail is a major business asset. The universal banks that dominate the European banking scene and much of cross-border banking are now also increasingly dominant in the USA, exist for three of the four reasons outlined above - all but the third. Economies of scale and scope have long been exhausted and diseconomies of span of control compete with lack of focus as the main drivers of organisational inefficiency. But by bundling the systemically important activities with the not systemically important activities, the entire organisation falls under the government’s bail-out umbrella. It is time to see a lot more and a lot smaller banks.
For the time being, banks that are too big, to interconnected, too complex or too international to fail are bound to be with us. For those I would support a proposal made by Raghuram Rajan and by Richard Herring, that such institutions be required to develop a bankruptcy contingency plan that would lay out how they would resolve themselves quickly and efficiently. Such a “shelf bankruptcy” plan would require banks to track and document their exposures much more carefully than they do now and in a timely manner. An insolvency plan is just as vital as a business plan for a financial institution in the too big to fail category. As Governor Mervyn King said in his 2009 Mansion House speech: everyone should have a will, including banks.
(7) Restrict limited liability to prevent excessive risk taking and reduce the size of banks
Incentives for excessive risk taking take many forms. An obvious one is limited liability. With limited liability, an investor (shareholder) can at most lose the value of his investment. The non-linearity in the pay-off function for the shareholder this creates, encourages placing more risky bets: losses beyond a certain magnitude are not born by the shareholder. Gains of any size are appropriated by the shareholders.
The combination of limited liability and leverage means that bets of almost any size can be placed by investors with this distorted, asymmetric payoff function. This can be done through conventional leverage (borrowing) or through leverage embedded in derivative contracts. A simple way to mitigate this problem is not to permit highly leveraged financial institutions (other than tightly regulated narrow banks, insurance companies and pension funds) to be limited liability companies. Instead, partnerships and other forms of unlimited, joint and several liability should be required. Partnerships and similar arrangements were the norm for investment banks until the 1990s. It is worth considering the removal of limited liability protection from highly leveraged financial entities with considerable asset-liability mismatch. This would no doubt also help keep down their size, by any metric of size.
(8) Create effective special resolution mechanisms for all systemically important financial institutions
Failure of a systemically important financial institution, that is default on its debt or insolvency, is a no-no because under most past bank restructuring and insolvency procedures, it has meant the destruction or at least the serious impairment of the insolvent financial institution as an organisation. There is no reason why a bank or other financial institution could not continue to perform, without any interruption, its systemically important functions at the same time that the Administrator/Conservator of the special resolution regime (SRR) for this bank or ofi informs the unsecured creditors that they have become shareholders. Resolving the legal issue of insolvency of a bank should not, in an merely minimally intelligently designed legal and regulatory structure, mean the collapse of the organisation or even its paralysis for a single instant.
There has to be absolute clarity about the seniority of the different classes of unsecured creditors (which is another reason for taking the tripartite and quadripartite repos out of the banks), but once the seniority ranking of all the unsecured creditors is established unambiguously, restructuring an insolvent financial institution and recapitalising it out of the claims on the banks held by the unsecured creditors, need take no time at all. The insolvent bank could continue to engage in new lending and new borrowing (perhaps with the new flows even guaranteed by the state) at the same time that the old unsecured creditors are taken to the cleaners, by having their claims written down or converted into ordinary equity.
In banking and most highly leveraged finance, size is a social bad. Fortunately, there is quite a list of effective instruments for cutting leveraged finance down to size.
- Legally and institutionally, unbundle narrow banking and investment banking (Glass Steagall-on-steroids).
- Legally and institutionally prevent all banks (narrow banks and investment banks) from engaging in activities that present manifest potential conflicts of interest. This means no more universal banks and similar financial supermarkets.
- Limit the size of all banks by making regulatory capital ratios an increasing function of bank size.
- Enforce competition policy aggressively in the banking sector, by breaking up banks if necessary.
- Require any remaining systemically important banks to produce a detailed annual bankruptcy contingency plan.
- Only permit limited liability for narrow banks/public utility banks.
- Create a highly efficient special resolution regime for all systemically important financial institutions. This SRR will permit an omnipotent Conservator/Administrator to financially restructure the failing institutions (by writing down the claims of the unsecured creditors or mandatorily converting them into equity), without interfering materially with new lending, investment and funding operations.
The Geithner plan for restructuring US regulation is silent on the too big to fail problem. That alone is sufficient to ensure that it will fail to result in a more stable and safer US banking and financial system. In the UK, the otherwise enlightened head of the FSA, Adair Turner, does not see a problem with banks of huge size and with a staggering range of unrelated or conflicted activities. Of all the parties that matter, only the Governor of the Bank of England, Mervyn King, is clear that ‘too big to fail’ is at the heart of the financial crisis we are trying to exit and will be at the heart of the next financial crisis that we are preparing so assiduously.
The Chancellor of the Exchequer, Alistair Darling takes the cake in the bigger is better stakes. He appointed “Win” Bischoff, the former chairman of Citigroup (appointed interim CEO for Citigroup in December 2007 after Chuck Prince bit the dust), to co-chair the writing of a report on UK international financial services - the future, published on May 7, 2009. That’s rather like asking the Ayatollah Ali Khamenei to write a report on who won the Iranian presidential election. It really is the most ridiculous appointment since Caligula appointed his favourite horse a consul. You will not be surprised to hear that the report does not consider the size of UK banks to be excessive. International cooperation is necessary if we are to solve the too big to fail problem. I am not holding my breath.
Broad Agreement Reached on Derivative Oversight
As Congress prepares to debate new rules for governing financial markets, federal regulators are taking steps to keep their turf wars from getting in the way of regulation.
The two agencies responsible for overseeing financial trading have reached broad agreement over how, for the first time, to regulate the vast market in derivatives -- complex investments that last year magnified the problems spreading among financial firms.
At a congressional hearing yesterday, Securities and Exchange Commission Chairman Mary L. Schapiro proposed that her agency oversee derivatives linked to stocks, bonds and securities and that the Commodity Futures Trading Commission oversee all other derivatives. CFTC Chairman Gary Gensler, sitting beside her, didn't offer his own proposal, but a spokesman said Gensler agrees with Schapiro, except on one outstanding issue.
The multitrillion-dollar derivatives market, which currently isn't regulated, enables financial firms to speculate on whether stocks, bonds, currencies and natural resources, among other things, will rise or fall in value. A particular type of derivative called a credit-default swap exacerbated the financial crisis and contributed to the collapse of American International Group, which made bets on derivatives it could not afford. Credit-default swaps, which are linked to the value of bonds, would be overseen by the SEC under the proposed agreement.
The accord between the SEC and CFTC awaits action by Congress, which a decade ago exempted derivatives from regulation. In a plan for retooling financial regulation announced last week, the Obama administration proposed new rules and heightened oversight for derivatives and the firms that trade in them. But the administration left the division of labor up to the SEC and CFTC, both independent agencies.
In the past, the two agencies have clashed over which body had the best claim to oversee this market. The Obama administration had discussed a proposal to merge the two agencies but backed off the idea in part because of opposition on Capitol Hill, where different committees have jurisdiction over the SEC and CFTC. The derivatives market, valued at more than $400 trillion, is important both because so many financial firms participate in it and because the trading can affect the underlying assets. For example, trading in a credit-default swap linked to a corporate bond can influence the interest rate a company has to pay to borrow money.
Schapiro, Gensler and others testified before the securities, insurance and investment subcommittee of the Senate Banking Committee. Still being negotiated between the SEC and CFTC is oversight of derivatives linked to indexes -- for instance speculating on whether the Dow Jones industrial average will rise or fall. At the hearing, Gensler pushed for more aggressive regulation than the Obama administration has requested. Obama's proposal calls for derivatives to be traded through "central clearinghouses," which would collect data about the market and require that buyers and sellers allocate enough money to cover any trades.
Gensler wants to go a step further and require that derivatives be traded on electronic exchanges, just as stocks are traded on the New York Stock Exchange and the Nasdaq. A derivatives exchange would offer the advantages of a clearinghouse but also provide public information about the pricing and volume of trades. Non-standard derivatives would be exempt from much of this regulation. These are derivatives linked to highly complex investments, such as securities composed of mortgages and other kinds of debt. But Gensler and Schapiro said it would be important to be vigilant about policing this market.
Obama Closes Doors on Openness
As a senator, Barack Obama denounced the Bush administration for holding "secret energy meetings" with oil executives at the White House. But last week public-interest groups were dismayed when his own administration rejected a Freedom of Information Act request for Secret Service logs showing the identities of coal executives who had visited the White House to discuss Obama's "clean coal" policies. One reason: the disclosure of such records might impinge on privileged "presidential communications."
The refusal, approved by White House counsel Greg Craig's office, is the latest in a series of cases in which Obama officials have opted against public disclosure. Since Obama pledged on his first day in office to usher in a "new era" of openness, "nothing has changed," says David -Sobel, a lawyer who litigates FOIA cases. "For a president who said he was going to bring unprecedented transparency to government, you would certainly expect more than the recycling of old Bush secrecy policies."
The hard line appears to be no accident. After Obama's much-publicized Jan. 21 "transparency" memo, administration lawyers crafted a key directive implementing the new policy that contained a major loophole, according to FOIA experts. The directive, signed by Attorney General Eric Holder, instructed federal agencies to adopt a "presumption" of disclosure for FOIA requests. This reversal of Bush policy was intended to restore a standard set by President Clinton's attorney general, Janet Reno.
But in a little-noticed passage, the Holder memo also said the new standard applies "if practicable" for cases involving "pending litigation." Dan Metcalfe, the former longtime chief of FOIA policy at Justice, says the passage and other "lawyerly hedges" means the Holder memo is now "astonishingly weaker" than the Reno policy. (The visitor-log request falls in this category because of a pending Bush-era lawsuit for such records.)
Administration officials say the Holder memo was drafted by senior Justice lawyers in consultation with Craig's office. The separate standard for "pending" lawsuits was inserted because of the "burden" it would impose on officials to go "backward" and reprocess hundreds of old cases, says Melanie Ann Pustay, who now heads the FOIA office. White House spokesman Ben LaBolt says Obama "has backed up his promise" with actions including the broadcast of White House meetings on the Web. (Others cite the release of the so-called torture memos.) As for the visitor logs, LaBolt says the policy is now "under review."
Not Paying the Mortgage, Yet Stuck With the Keys
A growing number of American homeowners are falling into financial limbo: They're badly behind on payments, but their banks have not yet foreclosed. The backlog of seriously delinquent mortgages, which so far affects about 1 million borrowers, is a shadow over hopes for a rebound in the nation's housing markets. It masks the full extent of the foreclosure crisis and threatens to depress prices even further just as some parts of the country are hinting at recovery. For lenders, it could portend even more financial losses tied to the mortgage meltdown.
"It just means foreclosure rates are going to keep rising," said Patrick Newport, an economist for IHS Global Insight. Rising mortgage delinquencies were at the root of the recession, and many economists say an economic recovery will be difficult until the housing market recovers and home prices stabilize. And even though a delayed foreclosure can be a blessing for some troubled homeowners, for others, it simply prolongs the financial distress, leaving them on the hook for the condition of the property. Even if they move out, they cannot move on.
"I have even begged them for a foreclosure," delinquent mortgage-holder Charlotte Jensen said. When she realized she couldn't save her Glen Allen home last year, she filed for bankruptcy, packed up her family and moved out. Nearly a year later, Bank of America has yet to take back the home. During the first quarter of this year, the share of all homeowners seriously delinquent on their mortgage but not yet facing foreclosure more than doubled to 3.04 percent, or about $227 billion in loans. There was a total of $97 billion in such loans during the same period in 2008, according to Inside Mortgage Finance.
In more prosperous times, the rate is much lower -- it was less than 1 percent in the first quarter of 2007, according to the industry publication. Some of the backlog reflects the inability of lenders to keep up with the swelling rolls of delinquent properties. "Lenders are having an immensely difficult time handling the capacity. They are torn between loan modification, short sales, foreclosures, and they are finding they can't do all these things at once, and do them well, so we're seeing a lot of things falling through the cracks," said Howard Glaser, a housing industry consultant and a housing official during the Clinton administration.
But some of the backlog also reflects an intentional slowdown in the pace of foreclosures as government and industry step up efforts to help borrowers who want to save their homes. Fannie Mae and Freddie Mac, the government-run mortgage financing companies, put a temporary moratorium on foreclosures late last year and many of the country's largest lenders followed suit. That gave some lenders more time to determine which borrowers could benefit from government help.
The glut of foreclosed homes on the market has already pushed down prices across the country. Existing-home prices fell another 16.8 percent in May compared with a year ago, according to industry data released yesterday. The overhang of homes in limbo means that foreclosure rates are likely to increase dramatically during the second half of this year and into 2010 as lenders work through the backlog, said Bob Bellack, chairman of Zetabid, which auctions foreclosed properties.
"Prices will fall to the point where you have equilibrium, and it won't reach that until there is no longer this foreclosure overhang," Bellack said. This could in turn put renewed stress on financial firms that carry mortgages or mortgage-backed securities on their books. As a general policy, many firms have been marking down the value of those assets as the loans become delinquent. But once the homes go into foreclosure and are sold, their value could decline even more, prompting another round of losses at financial companies.
For some homeowners, the foreclosure delays have provided needed breathing room to try to save their home, giving them a chance to live for free for a while or to work out a deal to save their property. "I think everyone has come to a realization that efforts to try to mediate are preferable to foreclosure right now," said David Berenbaum, executive vice president of the National Community Reinvestment Coalition, a nonprofit group.
But housing experts say that once borrowers are seriously delinquent -- defined as 90 days overdue on a mortgage -- some are too far behind to help or have already given up. According to a March report from NeighborWorks America, a large housing counseling group, 27 percent of homeowners who go to a housing counselor after missing three or four monthly payments end up in foreclosure. That figure jumps to 60 percent for those who have missed more than four payments before seeking help.
In better times, lenders tended to begin the foreclosure process after three months, said Guy Cecala, publisher of Inside Mortgage Finance. Now it is not unusual for it to take nine months for the process to begin, he said. "No one is in a rush, lender-wise, to deal with the property," he said. "If you have to sell at a loss, why rush?" Lenders traditionally write down the value of the home six months after an owner stops making payments, but the total loss is not recorded until the property is sold in foreclosure, said Mark Zandi, chief economist of Moody's Economy.com.
"Some may feel that the property is worth more than the market can bear at this time, and they are willing to wait until" the market improves, he said. "They don't want to sell it into a completely depressed market." Once underway, the foreclosure process is governed by a hodgepodge of state and local laws and the time it takes to get through the process varies by place. The process can also vary based on the original lender, on the current owner of the loan and on whether the borrower has filed for bankruptcy.
During the period that precedes final foreclosure, homeowners still have the legal obligations that come with ownership. Though in practice many borrowers who have stopped making mortgage payments may do little to look after a home. "During that period, where the property is in limbo, until there has been a sale of the property, the homeowner is still the owner, technically," said John Rao of the National Consumer Law Center. "It used to be that they wanted to foreclose as quickly as possible. . . . [Now] it's like this hot potato that nobody wants."
Even seriously delinquent borrowers can restart negotiations with lenders to stay in their homes with a modified mortgage or persuade them to accept a short sale, which involves a homeowner selling the property for less than the outstanding mortgage balance and then turning the proceeds over to the lender to satisfy the loan. Jay Brinkmann, chief economist for the Mortgage Bankers Association, said his industry is doing its best to work through the backlog while carrying out federal foreclosure prevention programs.
"If a lender has a house that they know they will have to sell eventually," he said, "they almost always want to sell it as quickly as possible because of the interest cost of holding the loan on the books, in addition to costs like taxes, keeping the grass cut and other maintenance." More than ever, foreclosure has become an unattractive outcome for lenders. "What we're seeing more and more right now are cases of a lender threatening foreclosure and the foreclosure sale is canceled at the last minute," said Jeanne Hovenden, a Richmond bankruptcy attorney, who handled Jensen's case. "It's more like the lenders don't want to own any more real estate and are using foreclosures as a pressure tactic."
The Jensens bought their home in 1999 and were able to make their payments comfortably until refinancing. Since moving out last July, they have not received a foreclosure sale notice even after hiring an attorney to encourage Bank of America to speed up the process. Jensen visits her home weekly to ensure it hasn't been vandalized or taken over by squatters. She pays landscapers to keep the lawn mowed. When the home caught fire in January, the police department knocked on the door of her new home, confused about whether to notify her or the bank. When neighbors complained about the mess left from the fire, Jensen returned to clean up.
A Bank of America spokeswoman, Jumana Bauwens, said the delay was caused, in part, by the fire. She said the home has since been referred to foreclosure. "The company makes every attempt to find a home retention solution for a borrower before proceeding with a foreclosure," she said. For the Jensens, the delay has extended a painful period. "There was a sense of responsibility that until someone says we no longer own that property, we wanted to make sure it's handed off correctly," Jensen said. "We could have walked away like everyone else and said, 'We don't care.' But we loved our neighbors and our neighborhood. We hold ourselves responsible."
Housing, unemployment woes leave movers shaken
Sinking home prices and a weak job market have forced normally restless Americans to stay put in an uncharacteristic shift that has, among other things, clobbered the moving industry. "Property values have dropped so much, people can't pick up and move the way they used to," said Michael Hicks, a demographer at Ball State University in Indiana who has tracked the nationwide slowdown using data from several sources, including moving companies.
That industry data mirrors a Census Bureau report that looked at moves in 2008, said William Frey, a demographer at the Brookings Institution in Washington, D.C. "The annual migration rate has gone way down to historic low levels," Frey said. "This includes long-distance moves and moving across town."
During the 1950s and 1960s, Frey said, as many as 20 percent of Americans moved in any given year. Mobility rates slowed to 15 percent to 16 percent during the 1990s. But in 2008, only 11.9 percent of Americans moved, he said. The stay-put trend has hurt moving companies, according to Stephen Weitekamp, president of the California Moving & Storage Association, whose 430 member firms offer full service relocations.
"There's nowhere for people to go," Weitekamp said, adding that the real estate slump has limited crosstown moves, while the weak job market has hurt corporate hiring. "Even people who are looking to retire and relocate are watching their home values deteriorate, and that makes them hesitate," he said. Amy Messinger, co-owner of Cummings Moving Co. in South San Francisco, said this is the worst slump anyone in the local industry can remember.
"There are fewer moves and fewer services per move," Messinger said, as even those who do move more often pack themselves instead of hiring help to box their belongings. Traditional movers also are getting more competition from self-service options like storage units that are delivered to homes, packed by the occupants and picked up and shipped across town or across country. Brian Burks, general manager of PODS of San Francisco, said his business has continued to grow but at a slower rate.
"It's definitely affected by the economy. There are just not as many people moving," Burks said. Other alternatives to traditional moving companies include online bidding sites like uShip.com. These sites allow people to post an inventory of their belongings and specify dates and locations for pickup and delivery. Buyers can read reviews of past service before making a choice among any bids that are offered.
Traditional movers also have been hit by a weak job market that has put a damper on long-distance transfers, according to Ed Melton, executive vice president for Chipman Relocations, an Alameda firm with many corporate clients. "Companies are not hiring at anywhere near their normal volumes, and if they do fill a position, they try to fill it locally," Melton said. "There's been a pretty dramatic downturn in corporate relocations."
Movers hope business will improve this summer, typically their busy season as people wait for school recesses and good weather to pull up roots. "Things are definitely picking up," Messinger said. But in the face of changing migration patterns and a more competitive landscape, she is also getting into new lines of service, such as working with interior designers who ship valuable pieces. "Those of us that are surviving are learning how to diversify and be creative and think outside of the box," she sai
Credit-Card Companies: Who Qualifies Now?
After years of getting Americans hooked on credit, card companies are slashing limits and weaning themselves off all but the safest customers. Terry Mazzera has worked to keep her credit score above 730, paying bills on time, sending in more than the minimum credit-card payment each month, and keeping a comfortable gap between her balance and credit limit. But a couple of weeks ago, the 62-year-old Hercules (Calif.) resident got a letter from a credit-card company saying that her limit had been cut from $9,500 to $6,500—just about $400 above the amount she owed on the card.
The primary reason: She was a late on a payment on a separate department store card. Her debt-to-limit ratio on the card suddenly zoomed up from 64% to 94%, and she expects her credit score will be damaged. The ratio is a key component that credit bureaus use to determine creditworthiness. "It's not right," said Mazzera, a project assistant at a construction company. "I worked very hard to keep my credit."
Mazzera is part of a growing number of Americans who are seeing their credit limits slashed. Even people with good jobs, low balances, and solid payment histories could be seeing their credit scores slip through no fault of their own. About 16% of customers had their limits reduced between April 2008 and October 2008, according to a recent study by Minneapolis-based FICO (FIC), which developed the Fair Isaac scoring model used by credit bureaus to evaluate default risk. But only a fraction of those customers would be considered risky. Jittery banks, eager to reduce potential risk, appear to be targeting many borrowers with low-balance or inactive accounts.
About 11% of customers who saw their limits cut had no "risk triggers" during that period and generally had very high credit scores. Risk triggers include late payments, excessive cash advances, check bouncing, collecting unemployment, or having a mortgage in an area where property values are plummeting. "This is blindsiding people," said Evan Hendricks, author of Credit Scores & Credit Reports (Atlas Books). "For a significant portion of people having their credit scores go down, it had nothing to do with what they did. This is the system making credit scores go down. This is a new thing in history."
There's no way to know how many good credit scores are being lowered by the credit limit cuts. FICO said its study showed that borrowers whose available credit was cut did not see a change to their median FICO score, which remained at 770. But the survey ended in October 2008, just as the financial crisis was beginning. It's unclear what has happened since then. Even a small FICO score drop in today's environment of tight credit can make the difference in getting a mortgage, a car loan, or another credit card, and it can have an impact on the interest rate a borrower pays.
The FICO score ranges from 300 to 850 and the best mortgage rates are generally given to borrowers who have at least about 730. The credit limit reductions are confusing to customers because many borrowers have credit cards so that "when a rainy day comes along they can use it," said Linda Sherry, spokeswoman for Consumer Action, a San Francisco-based nonprofit consumer education and advocacy group. "It's hard for consumers to understand because before the credit-card companies were almost pushing credit," Sherry said. "Now they're taking it back, even for people who were doing nothing wrong."
Banks are cutting limits in the face of a deteriorating economy. U.S. credit-card default rates reached record highs in May, near or even above 10% for Bank of America (BAC), American Express (AXP), Citigroup (C), and Capital One (COF), according to Reuters. The worsening unemployment situation is causing banks to worry that even good customers could quickly become risky customers. As a result, the companies are preemptively slashing credit lines, especially those that aren't being used.
"The single biggest indicator of a person's ability to repay is whether they have a job, and economists say unemployment could hit 10%," said Peter Garuccio, spokesman for the American Bankers Assn. "Issuers say their losses track closely with unemployment and they have to minimize exposure." Garuccio said some customers who think they're excellent customers might be riskier than they think. Somebody who just pays the minimum payment each month isn't the ideal customer, he said. "Somebody who is paying more than the minimum and not carrying a balance is a great customer."
Curtis Arnold, founder of Cardratings.com, said the same customers that banks were aggressively soliciting are now making them nervous. "The irony of this is that somebody who carried a balance was their [the banks'] bread-and-butter customer," Arnold said. "Now that same customer is a threat." The banks might be tightening available credit in reaction to new federal legislation, taking effect in the middle of next year, that will restrict how credit-card companies raise rates.
Among the other rules designed to benefit customers, banks will only be able to hike rates on existing balances if a customer is 60 days late on a payment, and it must provide 45 days' advance notice before increasing rates. It pays in this environment to keep the balance-to-limit ratio below a third and keep a close eye on any changes to credit reports, experts say. Author Hendricks suggests consumers try to pay down balances or convince lenders to restore limits. Borrowers can access a free credit report once a year from each of the three credit bureaus at www.annualcreditreport.com. On Myfico.com, customers can buy their TransUnion and Equifax (EFX) FICO scores for $15.95 each. Experian (EXPN.L) sells reports and scores on Experian.com.
Chinese Stats Official Says Economic Growth Last Year Was Slower Than Many Thought
As confidence in the prospects for China’s economy this year has become more widespread, a new picture of its recent performance has also emerged – one that could finally make it easier to compare China’s economy to those of other big countries. In an unusual essay, Guo Tongxin, an official at the National Bureau of Statistics, gives estimates for recent changes in China’s gross domestic product that follow the international convention of quarter-on-quarter comparisons. That’s a technical-but-important departure from China’s usual practice of describing year-on-year growth – and the figures paint a very different view of China’s economy over the last year or so than the headline numbers China has previously announced. (The article, published Tuesday, carries a disclaimer saying it represents Guo’s personal views, not those of the bureau.)
China’s traditional method compares GDP – and most other indicators – to the same period in the previous year. The U.S. and most other developed economies report GDP’s changes relative to the previous quarter, which gives a clearer picture of the most recent trend. But with the onset of the financial crisis, China’s statistics bureau has been working to improve the transparency and quality of its data. Among other changes, it has promised to start regularly publishing quarterly GDP growth rates in 2010. Many private-sector economists already try to make such estimates, but complain they lack sufficient information to do so accurately.
The new estimates from Guo, which only cover 2008 and early 2009, may be a surprise for skeptics who suspect that China’s statistics officials are only capable of reporting nice-sounding numbers. These figures actually show the slowdown in the fourth quarter of last year was even sharper than most outside economists had believed. Economists surveyed by the Journal in February had, on average, estimated that fourth-quarter GDP expanded at an annualized rate of 2.1%. Guo cited what he called a preliminary estimate that fourth quarter GDP grew 0.1% from the previous quarter, equivalent to an annualized rate of just 0.4%.
The headline year-on-year growth rate announced at the time, by comparison, was 6.8% — a gap that clearly shows how quarterly and annual growth rates can give very different pictures of economic turning points.
In a recent article, noted China economist Albert Keidel said the preference for year-on-year comparisons “illustrates the choice made by China’s statistical authorities to use measures that are relatively stable and change only gradually.”
The year-on-year comparisons are not necessarily less accurate – the U.S. and other nations also report them – but their use does mean Chinese authorities “give up measures that present a more timely picture of what happened to the economy in the immediately preceding quarter or month,” Keidel wrote. That preference has come to seem much less desirable given the rapid changes in the economy over the past year, and has led to pressure on the statistics bureau to improve.
For the first quarter of 2009, when outside economists generally agreed with the bureau’s assessment that growth had picked up significantly, the difference isn’t so great. Guo’s preliminary estimate of a 1.5% quarterly expansion, equivalent to 6.1% annualized rate, is within the 5% to 7% range that most private economists came up with at the time. Guo also said growth for the second quarter is likely to accelerate further to above 2.0%, equivalent to an annualized increase of more than 8%.
Still, it’s notable that the bureau only disclosed the low estimate for fourth-quarter growth several months after the fact, when the government is more confident the economy is recovering. It’s not alone — the World Bank and several investment-bank economists have recently raised their forecast for China’s growth this year, citing the bigger-than-expected effect of the government’s stimulus programs. But it’s hard to escape the feeling that the statistics bureau is still sensitive to the political implications of the numbers it publishes.
One Third of UK Prime Mortgages to Slip Underwater
Fitch Ratings says that 15% of mortgage loans by value in UK prime RMBS master trust programs are in negative equity. The agency expects that to increase to 34% if house prices fall in line with Fitch’s expectations of a 30% house price decline peak to trough, which would mean a further 14% fall from today’s values. Of the 2.7 million prime mortgage loans totalling GBP 263 bn securitised through RMBS, more than GBP 39 bn of loans are in negative equity and this figure will rise further as house prices continue to fall.
Such an increase in isolation is unlikely to result in negative rating action, since a 30% peak to trough house price decline is already factored into current Fitch RMBS ratings. While prime borrowers are unlikely to default solely because the value of their house is less than the outstanding balance of their mortgage, Fitch expects default rates to be higher for borrowers in negative equity.
Up to the end of April 2009, Fitch estimates that Northern Rock’s master trust RMBS programme, Granite, with 32% of loans (by value) in negative equity, has the highest proportion and Barclay’s Gracechurch pool, with only 2% of loans in negative equity, has the lowest proportion. The report, Underwater - Exposure to Negative Equity in UK Prime RMBS analyses the proportion of UK prime RMBS mortgage loans in negative equity by region and by mortgage lender.
OECD Says Ireland Needs Tax Increases, Spending Cuts
The Organization for Economic Cooperation and Development said Ireland needs further cuts in public spending and tax increases to address its widening budget deficit. The “fiscal balance has deteriorated very sharply” and “substantial spending cuts and increases in taxation are required,” the Paris-based organization said in a report today. The country may experience “mild” deflation over the next two years, it said.
Ireland’s economy has been hammered by the collapse of the domestic property market and the global crisis, leaving the government grappling with a soaring budget shortfall. The OECD forecasts that Irish gross domestic product will contract 9.8 percent this year and 1.5 percent in 2010. Unemployment may rise to 14.8 percent next year. The recovery, which is likely to begin in 2010, will be “sluggish,” the OECD said. “There are risks that the recovery will be weaker than anticipated or begin later as it may be hampered by tighter fiscal policy or falling wages depressing real incomes.”
Some 73 percent of Irish companies plan to cut jobs over the next six months, according to a survey published today by Mercer. Almost half of Irish companies have frozen salaries or deferred pay increases in the past six months, while 9 percent have cut pay, the survey showed.
German Budget Headed for Massive Shortfalls
Chancellor Merkel's cabinet on Wednesday approved a draft budget plan which calls for 310 billion euros of new debt in the next four years. In 2010, Berlin is expected to set a post-war record for deficit spending. In the early years of Chancellor Angela Merkel's term in office, her finance minister, Peer Steinbrück, made a name for himself as being tight-fisted, debt averse and committed to balancing Germany's budget. That, though, was before the financial crisis hit.
Now, Steinbrück is struggling to find ways to pay for Berlin's suddenly profligate spending as it tries to buy its way out of the crisis. On Wednesday, Merkel's cabinet adopted a plan presented by Steinbrück which provides the framework for the next four years of German fiscal planning. In total, it calls for €310 billion ($436 billion) in fresh debt from 2010 to 2013, including a whopping €86.1 billion ($121.2 billion) for 2010, far and away the largest single-year budgetary hole in the history of post-war Germany.
The 2010 total could even top €100 billion depending on the development of expenses related to Germany's economic stimulus packages (worth a total of €82 billion) and its bank bailout fund (worth €500 billion). Germany's previous record for fresh debt in a single fiscal year was the €40 billion borrowed in 1996. Steinbrück's new plan calls for new debt to begin falling after 2010, with €71.1 billion necessary in 2011, €58.7 billion in 2012 and €45.9 billion in 2013. Speaking to the Berlin daily Tagesspiegel, Steinbrück spoke of a "mammoth fiscal policy task." In a Wednesday morning interview on German radio, the finance minister said that the 2010 deficit is "unique and will hopefully stay that way."
He said that the deep recession has forced the government to "take anti-cyclical measures that will hopefully stabilize the labor market and restart growth." The budget plan will likely mean that Germany will violate the European Union Stability Pact, which calls for members to keep public debt below 3 percent of gross domestic product. Steinbrück told the Frankfurter Allgemeine Zeitung that he anticipates the EU will initiate proceedings against Germany "at the end of this year or the beginning of next." He went on to say that the German budget likely wouldn't conform to Stability Pact rules until 2013 or 2014. In the face of the global recession, EU leaders have agreed to interpret the Stability Pact -- which is meant to ensure the stability of the common currency, the euro -- flexibly.
Steinbrück's budget prognosis comes just a few months before Germans go to the polls for general elections. A final plan will be hammered out by the new government, but the country's skyrocketing debt promises to play a significant role in the developing campaign. Indeed, Chancellor Merkel's Christian Democratic Union has included a pledge to cut taxes in its campaign platform -- a promise which has prompted an internal party debate about the wisdom of tax cuts amid a crisis which has led to higher public spending and debt as well as plummeting tax revenue.
Klaus Zimmermann, president of the German Institute for Economic Research (DIW), told the Munich daily Münchner Merkur on Wednesday that promises to cut taxes are "implausible" and said "I am left wondering why politicians don't place more stock in honesty." Steinbrück, a leading member of the center-left Social Democrats -- the junior partner in Merkel's governing coalition -- pledged that his party would not support an increase in value added tax. "Right now in the middle of the crisis, we should not begin a discussion about tax increases," he told the Frankfurter Allgemeine Zeitung.
Latest Schultz Shock: a 'bank holiday'
The top-performing letter that predicted the Crash of 2008 now predicts a confiscatory Franklin D. Roosevelt-style "bank holiday." But it's surprisingly sanguine about stocks -- in the (very) short term. The Harry Schultz Letter (HSL) was my pick for Letter of the Year in 2008 because it really did predict what it rightly called a coming "financial tsunami." But its performance in 2008 was still terrible, albeit arguably for technical reasons.
Now HSL has bounced back big-time. Over the year to date through May, it's up a remarkable 81.7% by Hulbert Financial Digest count, compared to 4.1% for the dividend-reinvested Wilshire 5000 Total Stock Market Index. Of course, simple arithmetic dictates that doesn't make up for 2008 -- over the past 12 months, HSL is still down 48.19% versus negative 32.63% for the total return Wilshire 5000. In fact, the damage inflicted by 2008 was so great that HSL is also under water over the past three years, down an annualized 14.89% against a drop of 8.18% annualized for the total return Wilshire 5000.
Still, over the past five years, the letter has achieved an annualized gain of 9.19%, compared to negative 1.26% annualized for the total return Wilshire 5000. This reflects its success in catching the post-millennium hard-asset bull market that caused me to name it Letter of the Year, for more conventional reasons, in 2005. And over the past 10 years, the letter still shows an annualized gain of 3.65%, against negative 0.86% annualized for the total return Wilshire.
In its current issue, HSL reports rumors that "Some U.S. embassies worldwide are being advised to purchase massive amounts of local currencies; enough to last them a year. Some embassies are being sent enormous amounts of U.S. cash to purchase currencies from those governments, quietly. But not pound sterling. Inside the State Dept., there is a sense of sadness and foreboding that 'something' is about to happen ... within 180 days, but could be 120-150 days." Yes, yes, it's paranoid. But paranoids have enemies -- and the Crash of 2008 really did happen.
HSL's suspicion: "Another FDR-style 'bank holiday' of indefinite length, perhaps soon, to let the insiders sort out the bank mess, which (despite their rosy propaganda campaign) is getting more out of their control every day. Insiders want to impose new bank rules. Widespread nationalization could result, already underway. It could also lead to a formal U.S. dollar devaluation, as FDR did by revaluing gold (and then confiscating it)."
HSL is still sticking with its 20-year "V" formation forecast, but emphasizes that within the current 10-year downtrend phase there will be rallies that will "last 1-2 years." It attributes its current success to "successfully trading almost daily, especially in commodity stocks (coal/potash/energy/ fertilizer/gold). Take profits constantly and rebuy on mini pullbacks. Prefer non-U.S. dollar companies; many such companies are listed in U.S. & Canada or Australia."
HSL says: "The world is staggering today between stagflation and net deflation right now; it varies widely around globe. Net deflation is a maybe 35% risk, due to toxics and/or deepening depression. Bit more likely, we'll slowly creep up to a dangerous 4.5% inflation on average, medium-term. But the wild card is the currency risk, which has a 50% (?) chance of boiling over and causing literally overnight (i.e. 24 hours) mega inflation in the asset markets."
Nevertheless, in the very short term, HSL's charting leads it to say: "we MAY not get a new bear market decline that many bears are predicting. Likewise, DJIA & S&P500 may build a Head-and Shoulders right shoulder." HSL's currently recommended allocation:
• 35%-45% Government notes, bills and bonds. (Not U.S.)
• 8%-10% Stocks (non-golds).
• 10%-30% Commodities, via futures, commodity stocks and/or physical assets.
• 35%-45% Gold stocks and bullion.
Close relationship between past warming and sea-level rise
Scientists from the National Oceanography Centre, Southampton, along with colleagues from Tuebingen and Bristol have reconstructed sea-level fluctuations over the last 520,000 years. Comparison of this record with data on global climate and CO2 levels from Antarctic ice cores suggests that even stabilization at today's CO2 levels may commit us to much greater sea-level rise over the next couple of millennia than previously thought.
In a paper in Nature Geoscience, a team from the National Oceanography Centre, Southampton (NOCS), along with colleagues from Tübingen (Germany) and Bristol presents a novel continuous reconstruction of sea level fluctuations over the last 520 thousand years. Comparison of this record with data on global climate and carbon dioxide (CO2) levels from Antarctic ice cores suggests that even stabilisation at today's CO2 levels may commit us to sea-level rise over the next couple of millennia, to a level much higher than long-term projections from the Fourth Assessment Report of the Intergovernmental Panel on Climate Change (IPCC).
Little is known about the total amount of possible sea-level rise in equilibrium with a given amount of global warming. This is because the melting of ice sheets is slow, even when temperature rises rapidly. As a consequence, current predictions of sea-level rise for the next century consider only the amount of ice sheet melt that will occur until that time. The total amount of ice sheet melting that will occur over millennia, given the current climate trends, remains poorly understood.
The new record reveals a systematic equilibrium relationship between global temperature and CO2 concentrations and sea-level changes over the last five glacial cycles. Projection of this relationship to today's CO2 concentrations results in a sea-level at 25 (±5) metres above the present. This is in close agreement with independent sea-level data from the Middle Pliocene epoch, 3-3.5 million years ago, when atmospheric CO2 concentrations were similar to the present-day value. This suggests that the identified relationship accurately records the fundamental long-term equilibrium behaviour of the climate system over the last 3.5 Million years.
Lead author Professor Eelco Rohling of the University of Southampton's School of Ocean and Earth Science based at NOCS, said: "Let's assume that our observed natural relationship between CO2 and temperature, and sea level, offers a reasonable 'model' for a future with sustained global warming. Then our result gives a statistically sound expectation of a potential total long-term sea-level rise. Even if we would curb all CO2 emissions today, and stabilise at the modern level (387 parts per million by volume), then our natural relationship suggests that sea level would continue to rise to about 25 m above the present. That is, it would rise to a level similar to that measured for the Middle Pliocene."
Project partners Professor Michal Kucera (University of Tübingen) and Dr Mark Siddall (University of Bristol), add: "We emphasise that such equilibration of sea level would take several thousands of years. But one still has to worry about the large difference between the inferred high equilibrium sea level and the level where sea level actually stands today. Recent geological history shows that times with similarly strong disequilibria commonly saw pulses of very rapid sea-level adjustment, at rates of 1-2 metres per century or higher."
The new study's projection of long-term sea-level change, based on the natural relationship of the last 0.5 to 3.5 million years, differs considerably from the IPCC's model-based long-term projection of +7 m. The discrepancy cannot be easily explained, and new work is needed to ensure that the 'gap is closed'. The observed relationships from the recent geological past can form a test-bed or reality-check for models, to help them achieve improved future projections.
Ilargi: For a PDF of Chris Whalen's June 22 statement to the Senate Banking Committee, on OTC derivatives, go here
Back to Basis for Securitization and Structured Credit: Interview With Ann Rutledge
To get some further insight into the world of securitization and cash flows, we spoke last week to Ann Rutledge of RR Consulting. A University of Chicago M.B.A., Ann has over twenty-three years of experience in financial valuation and risk analysis, and special expertise in the microstructure of exchange-traded and OTC dynamic markets. She worked at Moody's in the golden era of structured finance, but left the agency when it became clear that models where being substituted for cash flow analysis at the behest of the Sell Side dealers. Ann is frequently retained as an expert witness in prominent securities litigations in the United States and Europe. And yes, Ann is the wife of Sylvain Raynes, the other half of "RR" Consulting. We know them both thanks to our mutual friend Josh Rosner.
The IRA: Thanks for taking the time to speak to us. Where in the world are you today?
Rutledge: I'm in London this week teaching a class on securitization. The course goes for a full week, which is not a bad way to handle it. A week is enough time to really go on an excursion through the details of the method, which is both an adventure and a great leveling experience for experienced practitioners and newcomers. I do two courses a year on securitization sponsored by Euromoney and we always get a very interesting group from around the world.
The IRA: We wanted to follow up with you after the presentation at the PRMIA event last week. Your talk was very provocative, but we really did not have time to get into the meat of the issue, thus our request. We think we got the punch line, though, which is that credit default swaps and collateralized debt obligations or "CDOs" share a common flaw, namely the lack of a cash basis for these derivatives.
Rutledge: Yes you did. And you asked a devastating question, namely whether OTC derivative markets that do not have a visible cash basis are legitimate or should even be allowed to exist. I have taught classes on securitization for years and don't often get people asking this basic question.
The IRA: Well, we started out on Wall Street with a Series 3 license from what was then called the National Futures Association. All of the contracts we knew at the time had very visible, easily observed cash markets upon which the derivative were based, thus the term "basis." The difference between a futures contract for T-bonds and a credit default swap is that the former is a real contract for a real deliverable, whereas the CDS trades against what people think is the cash basis, but there is no cash market price to discipline and validate that derivative market.
Rutledge: Well obviously the answer is that no, a contract or structure without a cash basis should not be allowed at all. You cannot have a derivative that is honest and fair to all market participants without a true cash basis.
The IRA: So to play devil's advocate for a moment, even if it were possible to synthetically create the equivalent of a basis and allow a trader to borrow the non-existent collateral for a single-name CDS contract, that would not address the problem? Is there any way to fix CDS contracts and other structures for which there is simply no cash basis market?
Rutledge: That is an interesting theoretical discussion, but the fact is that if you don't have a community of interest with the exposure and with the value at risk in a given name to really make it a market and believe in it, then who is to say whether the synthetic market works? That is always the classic problem with new markets. Communities of users or what The Chicago School calls "the market" that create a new vehicle don't want to come in under any kind of standardization or regulation. They exist to capture abnormal returns.
The IRA: Correct. But with CDS we have a community of dealers, not really a market, and everyone else is a second class citizen standing in the street. There is no true cash market where there is a deep community of traders, investors and locals who create true price discovery and make the pricing meaningful.
Rutledge: The way you state the problem really begs the question. When traders start to think of themselves as a community then by definition they start to be willing to come under some type of jurisdiction and accept some standardization. But here it is extremely important to say that Chicago has it wrong: people don't put on trades unless they can make money. If they can make money by the trades in the market that doesn't have a basis (I'm not speaking of earning spread for carrying positions-this is what is missing), then the traded price clearly does not represent fair value. If you can make money in such a market, then it is because somebody made a mistake.
The IRA: Or as your spouse Sylvain has said to us many times, price is not value.
Rutledge: Right, price is not value today, though if the market is rational and people are carrying positions that are marked to market, then in a long term sense it will be. The more commodity that you have to carry on your books, the less interested you are in abnormal returns and the more interested you are in carrying the goods at a rational cost of capital.
The IRA: Yes. This is why we believe that derivatives markets such as CDS and CDOs that have no cash basis tend to magnify speculative excesses, while derivative markets where there is a visible cash basis market to discipline investor behavior seem less unstable in terms of systemic risk. Is it fair to say that the point made in your presentation is that CDS and complex structured assets that do not have a cash basis should be banned by regulators?
Rutledge: You can say that. The first issue for me is that CDS and CDOs are an unexamined market. The fact is that the cash side is unexamined in these markets, because the cash analysis is owned by the rating agencies and they don't share all the vital details needed for pricing. An example of a vital detail would be how the cash flow analysis yields a number - a default rate or an implied price - that maps to a rating. Yet, the cash is the best indicator of what synthetic value really is. If the cash market were visible and could be examined by all participants, then it would give away the ability of the dealer banks to tax participants in the market and extract these abnormal returns.
The IRA: Correct. One of the things that has infuriated us over the past year or more is that all of the steps taken by Tim Geithner, starting at the Fed and now as Treasury Secretary, have only served to reinforce the monopoly of a few dealers in these markets. In the name of limiting systemic risk, investors who trade CDS are now forced to trade directly with dealers instead of amongst themselves as they can on a public futures exchange. Why should a large energy companies such as ExxonMobil (NYSE:XO) or Shell, which have far more capital and financial stability that JPM or any money center bank, be prohibited from trading energy swaps directly with other participants?
Rutledge: No they cannot. You see the thing that is really unique about structured risk -- I am not talking now about CDOs, just ABS and RMBS - is that where it is backed by an amortizing pool, it does have a theoretical profile where the performance of the security can easily be predicted and benchmarked against. This is the point of my presentation at the PRMIA event on June 10. The risk of making things like CDOs and CDS truly transparent is that the banks will be permanently disenfranchised: if the secret of how to price risky credit becomes democratized, and banks lose their special purchase on underwriting, then what will be their role?
The IRA: As you said during your presentation, the analysis of cash flows involves arithmetic, whereas the model culture used by the OTC dealers to obscure the true nature of instruments such as CDS and CDOs is about deliberately making markets less efficient. Is this fair?
Rutledge: Yes, that's right. Here's the issue. What we are really talking about is microbiology whereas the world is still thinking in terms of biology. In the case of a security with an observable basis, we are looking at the DNA of its risk and we can transform the risk profile via re-engineering. It is a matter of guesswork for securities that do not have this observable, tangible cash basis, where all that we see is the structure -- the outside of the package. Pricing ABS is about arithmetic, not ad hoc models or structures.
The IRA: So if you have a CDO that is comprised entirely of credit derivatives, for example, that is replicating one of your transparent, easily valued ABS deals, how do you feel about that?
Rutledge: That is OK so long as the structure tracks the cash basis; right now, it does not. As you know, structure is a function of the target credit quality, and target credit quality is a benchmark for the pricing. The amortization of ABS CDS/CDO and cash ABS risk follows essentially different processes: one is based on default write-downs, the other on actual cash distributions. Effectively, these two processes of amortization never converge, not even in the simplest of ABS transactions.
The IRA: So you do not object to a derivative so long as it tracks the cash basis. After all, if and when such a deal diverges from the cash market basis, that would put the risk back to the derivative's sponsor, who would be sued by the investors for fraud!
Rutledge: That's the way markets should work. Think about what is different between a dealer market, where you take an outright exposure but you can get out of it by passing it on to somebody else, and an ABS structure where the guarantee is built into the security.
The IRA: Correct, the ABS is self liquidating -- assuming that the underlying assets perform within the bounds of the assumptions in the structure.
Rutledge: Yes and because it is self liquidating the investors in the securitization have economic capital against the risk. The real essence of the ABS problem, or opportunity, is that the risk is going to expire before the economic capital in the structure expires. If you've correctly analyzed the risk, most ABS deals will converge on a "AAA" rating regardless of the initial rating of the security. And so any synthetic or derivative that tracks a cash ABS as its basis must understand and replicate the insurance component of the ABS. These deals are all self insured as well as being self liquidating. That is why the creation of structured securities that lack a cash basis is such an abomination for traditional investors in ABS, who are among the most risk averse investors.
The IRA: There are clearly some striking examples of this disparity. You compared the performance of an ABS from Ford (NYSE:F), which performs precisely as advertised in the offering to investors, with a late-production securitization from Countrywide, which never even came close to converging on "AAA," suggesting that the Countrywide deal was a fraud. You even suggested that F has been overpaying for its ABS deals to the tune of tens of millions of dollars a year. Explain that for our readers.
Rutledge: It is expensive for F in real risk-adjusted returns. At the beginning of the decade, we estimated that in issuing ABS, F may be paying $50 million more in annual interest costs than they would need on an apples-to-apples comparison with the benchmarks; but that excess protection is not, strictly speaking, why investors buy the paper. Investors can't measure the excess protection they receive; they are simply buying the F ABS because it tracks the cash basis and is entirely predictable. The markets always think in terms of "structure," but it is more than that; it is about numbers.
The IRA: So, again, to be the Devil's advocate, given the economic environment, the already record default rates in most asset classed, and the continuing pressure on consumers, how much variability from the norm do you expect to see in cash flows from conventional ABS? Is the variation in the loss experience in ABS deals from F and other traditional issuers going to break the admittedly conservative assumptions in terms of cash flow over the next several years?
Rutledge: Well, I think you are going to see a lot of variability. Look at the banks, who have been watching their internal cash flows falling for months now. For them there is no surprise. Hence their reluctance to disclose it. There really are two ways to answer your question. First is the subjective way, which is how different are the real cash flows going to be from what the armchair observer might think. The answer is quite a bit different. The armchair observer is thinking in market-average terms, while the actual experience of the structure from deal to deal could be very different, much higher or much lower. So the Ford deals are all trading above par on a theoretical basis. Nobody is pricing them at such a huge premium, but that is what they are worth in an economic sense.
The IRA: Your point about the cash flows at the banks is important. We have been observing a steady decline in the gross yield at many banks, which is a simple calculation of cash flow vs. outstanding loans and leases. As default rates rise and recovery rates fall, the total cash flow coming to the banks must continue to drop, probably through 2010 and beyond based on what we see in the channel now. What is the second method of pricing?
Rutledge: Now, the other way to answer the question is to ask: How stable has the performance been of the subordinate tranches of the more problematic structured deals, what people call toxic waste, been over the past 24-36 months? Paradoxically, because the underlying collateral experienced such high rates of default and prepayments early on, the risky tranches now tend to be very stable because they were only really ever worth 20 cents on the dollar when the deals went out! Conversely, it's the senior tranches that are highly uncertain. Will the collateral really ever throw off enough cash to make them repay in full?
The IRA: The investors who bought these toxic deals in the primary market will no doubt find great comfort in that fact.
Rutledge: The fact is that the performance of many toxic deals has been remarkably stable, but that does not change the fact that the deals were badly mispriced at inception. It is not even a question of marking these deals to market. If they had been valued properly at origination, they would not have been done in the first place. But, once in the market, the marks may also be wide of fair value. Jerry Fons, the former author of Moody's bond default studies, just published a paper examining how the ABX.HE 06-01, a synthetic ABS product, tracks the underlying cash ABS on a DCF basis. ABS.HE 06-01 is an index product developed and owned by Markit, a consortium of dealers. There are five sub-indices (AAA, AA, A, BBB and BBB-) made up of tranches taken from 20 large cash ABS deals (5% each) backed by vintages of late 2005 or early 2006 home equity loans. Obviously, the AAA index is composed of AAA-rated tranches from each deal, the AA index composed of AA-rated tranches, etc. It was designed for banks to hedge their long exposures and hedge funds to speculate on pricing anomalies. For benchmarks on the intrinsic cash flow value of the ABS tranches, Jerry used our secondary market re-rating metric, which reverse-engineers the transaction structure and follows the migration in value over time from origination to amortization. His paper shows that the trading on the ABX really did not reflect a movement away from par until early 2007: February 07, to be precise. Pricing these securities at par meant the market believed that each sub-index was appropriately discounted, given the risk. But, in fact, if you did the DCF analysis on the underlying collateral, you could have known that many of these deals deserved to be heavily discounted vs. the current market. Even the raw collateral data showed deterioration. But the ABX did not reflect this information.
The IRA: So the ABX is not a good indicator of changes in the performance of the underlying ABS market? Whatever will our friends at CNBC, Bloomberg and the investor community who swear by the ABX do when they read this interview!
Rutledge: No, the ABX did not reflect the true loss and prepayment experience of the underlying collateral at all. The actuals, the cash basis, suggested that these securities really deserved to be heavily discounted to par. For example, fair value of the AA tranche at closing was only about 40 cents. And now, if you compare the volatility of the ABX traded prices with the volatility of the cash market, "fair value" price, the cash price is much more stable.
The IRA: Ha! Why do we suddenly have this image of chimpanzees sitting on trading desks and responding to artificial stimulus dispensed by the large dealer banks? What proportion of people who trade ABX do you think understand what you just described? Is our supposition that most market participants trade these deals vs. bond yield spreads and not with an eye on actual cash flow performance correct?
Rutledge: Yes, that's right. You wake up in the morning and say "How do I feel about the market?" But that is not really the intrinsic value of an ABS or any structured asset.
The IRA: No and the Big Media never bothers to ask whether dealer-sponsored indices like the ABX have any connection to the actual cash basis. Do we perceive a pattern here? Is it just basic human weakness that keeps bringing all of us back to valuation shortcuts that all look like Merton models? Or is it that the deals, the rating agencies and the media have conditioned the markets to believe that such methods are effective?
Rutledge: It's a complex problem, in fact. It does seem to be basic human weakness to prefer religion to science or sociology. Modern financial theory is a religion; we believe that markets meld data into truth, but that the truth of markets is beyond the ability of any one person to comprehend, except some very special wizards who have the right recipes to decode it. One after another, the wizards are discredited, but our slavery to false ideas about markets continues. Part of the reason for this is the lock that The Chicago School of finance has had on financial thinking. A little objectivity would show that much of what we think is, in fact, a set of myths -- but myths that favor certain parties in the market at the expense of everybody else.
The IRA: Why is it that the media, even our friends at Bloomberg, never question these assumptions about market valuations? Is it laziness or that they just don't get it?
Rutledge: I am not too critical of the media. To start, I am not sure most of them understand the difference between subjectivity and objectivity. So they are just not ready for that message.
The IRA: They are not, alas, but that is one reason why we publish The IRA. So in the proposal from the Obama Administration to reform the securitization markets, it is proposed that banks retain a 5% "exposure" in all securitizations. Do you find this as amusing as we do given your work for investors involved in litigation against the sponsors of securitizations? The FASB is now telling the banks to bring 100% or the risk exposure back on balance sheet, but the Fed and Treasury are saying 5% risk exposure. And meanwhile investors are suing the sponsors of deals based on 100% of the exposure.
Rutledge: FASB in some sense has no choice. They never got the rules regarding securitization right and the IFRS was even further away from reality when it comes to securitization. If you go back to the original FAS 140 discussion paper, you can see where the debate came down in terms of on-balance sheet and off-balance sheet treatment. My position and Sylvain's too is that if you are going to the trouble of analyzing the intrinsic risk of a pool of receivables and you are putting capital against that risk, then all that matters is the integrity of the analysis of the structure. It does not matter on whose balance sheet the structure resides so long as the analysis of the cash flows is performed correctly. In that sense, GAAP was kind of far from a radical treatment of OBS treatment, but it was certainly closer than IFRS. Now that the market has fallen apart and given the pressures to harmonize IFRS with GAAP, which really has little credibility left, I expect to see the US move to a more European style of accounting for OBS vehicles. But a European standard, implemented in an Anglo-Saxon financial regime, is an invitation to abuse the standard.
The IRA: Give us some examples? Where is the next area of regulatory arbitrage for the major dealer banks?
Rutledge: Look at the proposals for using covered bonds to rebuild securitization. There is a great difference between how banks use covered bonds in an Anglo-Saxon market vs. the European model. In Europe, there is some attempt to size the risk and maintain a level of responsible leverage.
The IRA: Well, look at Denmark. We've spent a lot of time speaking to Alan Boyce about this issue. In the Danish mortgage market, the banks aggregate the risk into large trusts that have excess economic capital. The bond market manages the interest rate and market risk, instead of pushing these risk onto the consumer. So whereas a home owner in Denmark can effectively repurchase their mortgage at a discount in a rising interest rate environment, in the Anglo-Saxon world the home owner bears all of these risks. The Danes have essentially banned bad behavior by the banks and have created the most stable market for home finance in the world. You, the consumer/home owner, can examine the current market price of your mortgage every day in the newspaper because all of the Danish mortgage bonds trade on an affiliate of the NASDAQ/OMX. Wonder how long it will take our friends at the Fed and Treasury to figure out that we have a solution to the crisis affecting the US residential mortgage sector that is already extant and trading on the NASDAQ every day?
Rutledge: Yes, the Germans are shocked to see that there is gambling going on in the US mortgage market. Last year I was asked to look at a handful of prospectuses in the Canadian and US covered bond markets last year on behalf of a client, and none of them come to market with asset-liability parity. That means, none of them were set up to pay the investors off in full without recourse to the bank doing the securitization. Unlike Demark, most covered bond deals in the US and Canada come to market with liabilities in excess of asset values. This illustrates how the Anglo-Saxon interpretation of a seemingly safe and sound model like covered bonds can create opportunities for regulatory arbitrage -- if the authorities do not insist on tight underwriting standards and enforce same. In the Canadian and US covered bond deals, it is clear that there will be recourse to the lender since the NPV of the liabilities exceed that of the assets. So in this example, the "safe" model for a covered bond becomes an excuse to excessive leverage on-balance sheet!
The IRA: But are covered bonds, even with this notable defect, a more conservative model that what we have seen in the US? Are we close to God or is this just another ruse by the large dealer banks to hide unsafe and unsound practices?
Rutledge: Maybe. There is no panacea. There is enormous potential for abuse in covered bonds. The constituency behind the adoption of covered bonds by US regulators was pushed by Countrywide and WaMu. The proposal was adopted in 2007. All that a covered bond does is make legitimate what used to be illegal, but that banks were doing anyway, namely the substitution of collateral in securitizations and other undocumented transactions between the sponsor and the supposedly separate DE securitization trust. The invisible and illicit forms of recourse such as substitution and servicer cash advances by the sponsor that were never reimbursed are all now legitimatized by the covered bond model. The practice of bringing securitization deals to market that have an imbalance between the NPV of assets and liabilities is unsafe and unsound, but now it's legal!
The IRA: So you believe that all of the deliberate mispricing of securitization deals and the substitution of collateral that occurs today under the table could simply get worse in a covered bond model - at least one implemented by avaricious gringos who don't have to operate under the authoritarian political environment of Northern Europe? We have a lot of respect for the discipline of the Danes, but these are societies where individual choice is largely pre-empted by the state. We hear that the positive liberty crowd that surrounds President Obama are big fans of the European model. So give us you take on reform of the securitization markets. What should the US do to make these markets more transparent and fair to investors?
Rutledge: My answer is really boring and not very sexy. The first key issue is that we need to do to reform our markets is to have a standard vocabulary for the definition of what is a delinquency, a default, and loss. That is really boring, but that fact is that I can show you transaction documents for one deal after another where the bad acts are committed because these very definitions can be gamed. The accounting firms are so obsessed with liability and who takes responsibility when things do go wrong, that they never bother to ask why things go wrong with securitizations. But, we understand that the accounting framework was set up for corporate finance, so it is understandable that they would think about the "biology" of the problem - the whole company solution - rather than focusing on the appropriate level, the "microbiology" of these structures, where risk is measured at the pool or even loan level.
The IRA: No, we know the problem well. The audit firms rightly complain that they cannot bear the liability of these transactions, so they spend most of their time trying to ensure that somebody else bears the risk - instead of trying to identify and eliminate the sources of the risk. If you were the managing partner of PwC or Deloitte and you were working for a group of greedy, irrational banks that only care about next quarter earnings and have literally bought everyone in the political and regulatory worlds, what would you do?
Rutledge: The thing is that when you look at as many deals as I have and see that over and over again, the same issues cause deals to go wrong because you counted the loans at full face value or you counted loans that were not really contributed to the securitization, these are basic flaws. The basic rules of securitization, going back to the simple example of the F ABS deal, do work if people follow the rules - but this assumes that we have a government, auditors and regulators that will enforce the rules.
The IRA: So wait, are you saying that adopting and enforcing basic definitions as you have described would eliminate a lot of what's wrong with structured finance?
Rutledge: If everybody is playing by the same set of rules, whether you are talking about loan origination or securitization, then it becomes very hard to game the system. The lack of definitions is a huge problem. Here's the problem. At the very first step, when Citibank or another large bank buys loans from Countrywide or Associates or whomever, they don't believe the representations that the seller is making, and they don't have to because they can put the bad loans back to the seller. However, this is hidden recourse. The seller is not a highly rated company, yet the AAA investor in the deal Citi structures is ultimately relying on the seller's ability to substitute assets or buy them back at par. So therefore, within the supply chain, as the "capital" moves through the system in the form of the funded loan, it is ultimately a recourse problem back to the originator. So either you rely on the strength of the loan to guarantee the investment, or you dismiss the representations about the loans entirely and simply rely upon putting the loans back to Citibank or whoever is the sponsor in the event the deal goes wrong. In the former situation, you have a bona fide structured finance market; in the latter, you have plain vanilla corporate finance. If you choose the former, you need the measures in place to evaluate the strength of the loan. If you choose the latter, but you allow hidden leverage to build up on the bank's balance sheet that can't be measured -- because you are not operating in a granular structured finance world with pool or loan-level measures -- then you have an essentially unstable financial system.
The IRA: So how do you assess the decision by Advanta to accelerate one of their credit card securitizations. As we understand it, the losses on the securitization became so large that Advanta simply decided to buy-in the bonds at par to avoid precisely the sort of recourse claim and perhaps also litigation that you just described.
Rutledge: Funny that you ask about Advanta. We talked before about resizing the economic capital of a securitization as the pool of risk shrinks. The first time we ever did an analysis on a deal was on a transaction from Advanta's mortgage portfolio, which they had sold to JPM. Later, JPM turned around and sued Advanta in 2003, I believe, for making servicer advances to the securitization trust that were never reimbursed and that created an illusion of credit quality that was not real. We had identified the problem in the Advanta portfolio in 2001. In those days, according to our research, the servicer advancing problem was not widespread. But after 2001, it became more widespread, until you could say it was a problem for most of the market. To come full circle on the earlier point about covered bonds, servicer advancing is wrong only if you disallow recourse. If you allow it, by promoting covered bonds, you are simply legitimizing the deceptive practices that developed in the last decade. But, without an ability to track current credit quality in the ABS or MBS, you will not be able to detect the magnitude of the problem until it is too late.
The IRA: So how do we fix the problem without creating more opportunities for gaming the system? How do we make the buyers do the diligence? Can you fix this by merely creating consistent definitions?
Rutledge: These originators play this game over and over again and they don't get caught, in part because we do not have a common, standardized set of definitions for governing the most basic aspects of the securitization process. The buyers don't do the work and the accounting framework is a counterparty-oriented framework, not one that is focused on the underlying assets. So banks like Countrywide and WaMu originated and sold some truly hideous structures during the bubble, but the buyers only diligence was reliance upon recourse to these banks. It costs maybe 50bp for a buyer to get the data and grind the numbers to really diligence a securitization based on cash flows, even a complex CDO. But the cost to the buyer and the system of not doing the diligence is an order or magnitude bigger. If the Congress, the SEC and the FASB, and the financial regulators only do one thing this year when it comes to reforming the world of structured credit, then it should be to impose by law and regulation common standards for the definitions used in the marketplace.